Thursday, October 22, 2020

A very very simple explanation of monetary policy

Scale & weights | Aylmer, Quebec | Canadian Museum of History
 

This post is for my dad, who says he doesn't understand my writing but remains a loyal reader nonetheless.

I am going to try and explain one of the most important things that central banks do: monetary policy. We often see news clips in which bespectacled central bankers discuss their "inflation targets," or tell us that they are ratcheting interest rates up or down, or that they are engaging in "quantitative easing". The catch-all term that we use to describe what they are doing is monetary policy. But what does this mean? What is monetary policy?

Central banking is confusing, so here's what I propose. Let's find something simple, something we all intuitively understand. And then I'll show why monetary policy is like that simple thing. Hopefully that demystifies what is going on. I'm going to use a Canadian example, but it applies just as well to any nation.

K50, K75, and K106

People take their national system of weights & measures for granted. But we simply couldn't function as a society without a standard way of measuring things: kilograms, metres, seconds, or degrees Celsius.

A nation's system of weights & measures doesn't just manage itself. Take the kilogram. The Canadian Federal government had to push and prod for years to get the kg into popular usage. Canadians had historically relied on the imperial measurement system with its strange mix of ounces, drams and grains. In 1970, Pierre Trudeau passed the Weights and Measures Act, giving birth to the Metric Commission and its mandate to get Canada officially onto the metric system. Fifty years later we Canadians all reckon in terms of kilograms, grams, and a raft of other metric measures. (Ok, not entirely, I admit. I cook in Fahrenheit, not Celsius, and weigh myself in pounds, not kg. But I definitely don't drive in miles.)

The Canadian government's job didn't stop once the kilogram was widely accepted. It has continued to manage the kilogram ever since. The main thrust of this ongoing effort is to ensure that 1 kilogram is 1 kilogram all across Canada. No agency is more involved in this harmonization effort than the National Research Council of Canada, or NRC, the Federal government's research and development lab.

National Research Council building in Ottawa

The NRC's headquarters in Ottawa houses three individual physical kilogram weights. Known as K50, K75, and K106, these specimens represent Canada's official kilograms. Because Canadian manufacturers require incredible precision, they can periodically visit the NRC and calibrate their weights against K50, K75, or K106 to ensure accuracy. If the manufacturer's weights diverge by even a few micrograms from the NRC's official weights, they will have to be replaced with more accurate ones.

And so the definition of the kilogram diffuses across Canada, first from the National Research Council, then to industry, and finally to Canadians who consume carefully weighed products.  

The National Research Council's K50, K74, and K106 are in turn copies of the most important kilogram weight in the world, the International Prototype Kilogram. Manufactured in 1889, the IPK is stored at in the International Bureau of Weights and Measures (BIPM) in France. Scientists at the National Research Council used to periodically hop on a plane with K74 and fly to France to cross-check it against the IPK.

In 2018, the world stopped using physical artifacts to define the kilogram. The problem with using actual objects like the IPK and K50 is that over time they suffer from slight degradation. K50, for instance, began to display fluctuations of a few micrograms due to "tiny cracks in the surface which adsorbed and released water from the air." And so our standard for weight suffered. 

We now rely on a much superior non-physical standard for the kilogram, one that is defined in terms of Planck's constant. But even though the definition of the kilogram has changed, the National Research Council is still key in ensuring that the kilograms Canadians use are good kilograms.

The beginning of the long dash...

The National Research Council also maintains Canada's official time. Cesium atomic clocks are the world's most accurate method for recording the passage of time, of which the NRC's time standards office in Ottawa has several. The NRC broadcasts official time on the web, via short wave radio band, and by telephone. Faithful CBC radio listeners will all be familiar with the NRC's habitual: "The beginning of the long dash indicates exactly one o'clock..." For $7,500 per year, industrial customers can even get authenticated access to NRC time servers.

An NRC control room containing systems used to disseminate official time to the public, including the telephone talking clock, the CBC daily time broadcasts, and computer time clocks.

Precise timing is particularly important to the Canadian financial industry. Take the Investment Industry Regulatory Organization of Canada, or IIROC, which regulates the Toronto Stock Exchange and all the firms that deal on it. (IIROC is sort of like Canada's version of the SEC). To ensure that all market participants are on the same rhythm, IIROC sets its internal clock off of the NRC's clocks. All firms that trade in Canadian securities must in turn synchronize their clocks to IIROC's clock. And thus the NRC and its atomic clocks impose order on the chaos of the stock market. 

kg, s, and $

Now let's bring this back to monetary policy. 

The main suggestion in this article is that readers put the National Research Council and the Bank of Canada in the same bucket. Both institutions are responsible for upholding Canada's system of weights & measures. 

But whereas the NRC is in charge of managing physical measures, the Bank of Canada is responsible for managing the nation's key unit of economic measure, the $. So when you see news about the Bank of Canada and the dollar, and you start to get confused, consider reframing the news as if it was the National Research Council making policy changes to the way it manages the kilogram. Hopefully that will make the news more relatable.

The dollar is the universal sign we Canadians use to express economic value. It shows up in grocery aisles, at online stores, in our bank statements, and is used in our heads to calculate bills.

But like the kg, the $ must be managed. As I wrote earlier, the NRC originally defined the kilogram in terms of a physical artifact before switching to a non-physical construct. Likewise, a long time ago the Canadian dollar was set at 23.22 grains of gold. But these days the Bank of Canada (much like the NRC) measures the dollar in terms of a theoretical construct, a basket of consumer goods.

What does it mean to measure the dollar in terms of a basket of consumer goods? 

Each month government statisticians canvas store aisles and websites for price data which they use to calculate the cost of purchasing a basket of consumer goods. This data compilation is known as the consumer price index, or CPI. It includes items like groceries, rent, gas, etc. 

In its definition of the dollar, the Bank of Canada promises citizens that the $ unit will be capable of buying the same amount of consumer baskets from one month to the next. (It's a little more complicated than that, but that's for another post).

So then what are interest rates for?

Sometimes the Bank of Canada will make the news because it is increasing or lowering interest rates. What is happening here? Recall that the National Research Council had a number of tools for diffusing official time across Canada, one of which is broadcasting across channels such as the CBC. The Bank of Canada also has tools for diffusing its definition of the dollar across Canada. Interest rates happen to be its favorite tool.

If the dollar falls in value such that it is no longer powerful enough to purchase the appropriate quantity of consumer baskets, the Bank of Canada will increase rates. In theory, this pushes the dollar's purchasing power back up to target. And if the dollar is too powerful and purchases more baskets than the Bank of Canada's target, the Bank will decrease rates. This should nudge the dollar's purchasing power back down.

Updating the definition of $

So when experts discuss standards bodies like the National Research Council or the Bank of Canada, they are likely having two sorts of discussions. Half of their conversations will be about the definitions that these institutions uphold (i.e. should we define the kilogram using K50 or Planck's constant? Should we define the dollar in terms of grains of gold or consumer goods?). And the other half will be about strategies and tools for diffusing the standard across Canada (i.e. should we provide the public with more channels for accessing official time? Should we increase interest rates or keep them unchanged?)

The Bank of Canada is currently in the thick of the first sort of discussion. Every five years the Bank of Canada and the government come to an agreement about how the Bank will define the dollar for the ensuing five years. The next agreement is scheduled to be inked in 2021. 

Some people involved in this discussion want to adopt new definitions for the dollar. Recall that the Bank of Canada already uses consumer basket to define the dollar. One group wants to redefine the dollar in terms of nominal gross domestic product. Others want to add a reference to employment

Much like discussions about whether to redefine the kilogram in terms of Planck's law, this is a complicated debate, one that non-experts cannot easily access. But whatever the decision, you can be sure it will have implications for all Canadians. After all, the $ is a measure that each on of us uses on a daily basis.

Sunday, October 4, 2020

The ECB's digital euro: anonymous or not?

 

The European Central Bank (ECB) recently published a report that explores the idea of introducing a digital euro for use by the general public. This project is known as a central bank digital currency, or CBDC, and many other countries are exploring the same idea. John Kiff has a useful database here showing how far these projects have progressed.

Will the ECB's new euros-for-all be relatively open and anonymous like cash? Or will they require ID and permission like a bank account?

In short, the report says that anonymity may have to be "ruled out." It says that regulations do not allow anonymity in electronic payments, and the ECB must comply with regulations. I quote the passage below:
"While [anonymity] is currently the case for banknotes and coins, regulations do not allow anonymity in electronic payments and the digital euro must in principle comply with such regulations (Requirement 10)."
But I'm pretty sure the report is wrong on this. EU regulations do allow for anonymity in electronic payments. The Fifth EU Anti-Money Laundering Directive (AML5) exempts issuers of e-money/prepaid cards from collecting customer information as long as long as fixed monetary thresholds aren't exceeded. Yes, these exemptions are very small:

Source: Paytechlaw

So if the ECB believes that it must comply with existing regulation for electronic payments then surely a digital euro falls under e-money law, and thus it can have some anonymity. (Jerry Brito has pushed back on the first assumption, asking why a CBDC can't just occupy the same legal framework that has already been created for banknotes.)

By the way, the U.S. and Canada also provide such exemptions. That's why people can walk into a pharmacy and get a $200 Vanilla prepaid debit card without showing any ID and, say, buy food online for delivery. Or to make an anonymous donation.

Putting aside for the moment the ECB's views about payment anonymity, an interesting question is why democracies allow for small amounts of payments anonymity in the first place. 

On Twitter, we talk a lot about the civil liberties case for anonymity i.e. the right to stay anonymous. But that's not why regulatory exemptions to all-pervasive know your customer obligations exist. They exist because of political appeals to financial inclusion. Disadvantaged people often lack ID. To ensure that these people aren't locked out of the digital payment system, electronic money & prepaid card issuers are allowed to avoid collecting information when the amounts held are small.

So let's bring the conversation back to the ECB's report on a digital euro. Yes, the report did wrongly state that it can't legally provide anonymity. And yes, we can chide the ECB from a civil liberties perspective for not wanting to activate a feature for which it has legal right.

But given my earlier point about financial inclusion, a better critique is this:

The EU has chosen to build an anonymity exemption into payments law in order to ensure that all Europeans, including those without ID, can make digital payments. Why is the ECB choosing to avoid exploiting this exemption? In the very same report, after all, the ECB states that the decline in cash could "exacerbate financial exclusion for the 'unbanked' and for vulnerable groups in society, forcing the central bank to intervene." Isn't the ECB contradicting itself by saying that it wants to help the vulnerable while simultaneously refusing to activate a feature—anonymity—that might help reach this demographic?

Central banks such as the ECB are sailing into dicey political territory by choosing to pursue a new retail payment product. Who are they trying to serve, and why? More controversially, who are they choosing to not serve? Anonymity (or its lack) will be one of the most contentious design elements of a potential digital euro. Let's hope the ECB does a better job discussing this particular issue in the future. In this recent attempt it could be construed to be ducking behind non-exist laws rather than directly engaging with a tricky topic.

By the way, I understand why the ECB might not want to provide anonymity. The exemptions that AML5 permits are tiny. Is it even worth if for the ECB to exploit them? And let's face it, anonymity can attract bad actors. Due to their relative anonymity, iTunes and Steam gift cards are being repurposed by IRS and Social Security scammers as a safe way to extort payments from their victims. And ransomware operators have converged on bitcoin as a safe way to extort ransoms.


Balanced against the dangers of anonymity are peoples' very legitimate concerns about civil liberties and financial inclusion. It's a tough issue. I don't envy the ECB. 

Monday, September 28, 2020

Adopting a clean gold standard


 

Last month I wrote an article about banning gold mining. It received plenty of feedback from different parts of the internet. Some loved it, some didn't. [ GATA | Boing Boing | Hackernews ]

In this follow-up post, I want to outline a less draconian and more market-friendly alternative to banning gold mining.

But first, let me quickly reprise the original blog post. Unlike coal or oil or wheat, gold never gets consumed. We mostly "use" gold by holding it in vaults where it is kept safe from wear and tear. If people collectively want to hold more of the yellow metal, then a simple rise in price will suffice. After all, if the price of gold jumps to $4000/oz from $2000/oz then the world's gold hoards will have doubled. Voila, demand satisfied.

With price doing all the work of responding to higher societal demand, no new metal from mines is required. That's a good thing. The problem with gold mining is that it causes all sorts of environmental damage. That's why El Salvador, for instance, chose to ban gold mining back in 2017. Extending this ban to the entire globe would reduce all of the damage caused by mining without hurting gold's main consumers: investors, speculators, and hoarders.  

So that was the gist of last month's post.

In today's post I want to outline an alternative way to move in the same direction as a mining ban. The idea would be for a standards board, perhaps the London Bullion Market Association or the International Standards Organization, to create a new industry standard for gold called "clean gold." Unlike "dirty gold," clean gold would not be implicated in the environmentally damaging effects of mining. Environmentally-conscious gold investors would be able to migrate from their dirty gold to clean gold, which would likely trade at a premium to the dirty stuff.

Clean gold would be defined as all gold in existence before a fixed cutoff date, say December 31, 2023. Any gold produced after that would not be granted clean status. It would be dirty.

By committing to only buy and hold clean gold (i.e. the legacy already-mined stuff) a woke gold investor is choosing to avoid contributing to any additional mining-linked environmental degradation. These investors' collective choice to only buy pre-2023 gold would be a substitute for a gold mining ban. Together, they would be acting as-if gold mining had been banned by governments.

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One institution that could champion clean gold would be the London Bullion Market Association, or LBMA. The LBMA already maintains a set of standards that define London "good delivery" gold bars, including rules concerning permitted bar dimensions and purity. There are currently 8,790 tonnes of London good delivery gold, worth around $555 billion and accounting for about 5% of all gold ever mined. So the LBMA’s standards have a major influence on what sort of gold is considered legitimate for investment purposes.

The LBMA has already instituted some woke standards for good delivery bars. LBMA responsible gold guidance prohibits bars from qualifying as good delivery if they have been involved in financing conflict and the abuse of human rights. It also sets some environmental standards. For instance, the LBMA requires refiners who buy gold from artisanal miners to assist them in establishing processes to better use mercury.

How would the LBMA introduce a clean gold standard?

The LBMA could redefine its good delivery standard to be a clean standard by only allowing bars produced prior to the December 31, 2023 cutoff date to qualify. Alternatively, it could set up a second delivery standard, a "good & clean delivery standard," and anyone participating in the London gold market could choose their preferred standard.

Exchange-traded funds, say like the State Street's SPDR Gold Shares ETF, the world's largest gold ETF, would also be a natural set of institutions that could champion clean gold. Either in conjunction with an LBMA clean standard, or on it own, the SPDR Gold Shares ETF could commit to only holding gold bars produced prior to December 31, 2023.

Finally, major gold coin-producing mints like the Royal Canadian Mint and the US Mint could also apply a clean gold standard to the coins they produce.

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As I mentioned earlier on, clean gold would trade at a premium to dirty gold. Likewise, a clean gold ETF would trade at a premium to a dirty gold ETF and clean gold bullion coins would trade at a premium to regular bullion coin.

The reason for a premium is that the supply of clean gold would be fixed at the amount of gold in existence prior to December 31, 2023. But the amount of dirty gold is not fixed. Dirty gold includes not only all gold mined after 2023 but all pre-2023 gold. After all, an owner of a 1995 gold bar needn't seek clean status if they don't care for that designation.

If dirty gold were to ever rise to a premium to clean gold, then arbitrageurs would convert clean gold into dirty until the premium disappeared. There are no rules prohibiting movement from the clean to dirty designation. But careful, once dirty always dirty! There is no way to do the opposite, to convert dirty gold into clean in order to reduce the clean premium. The clean gold rules and standards prevent dirty gold conversions.

How large might the premium get? If the gold investment world were to completely migrate over to clean gold, quite high. Most existing gold is currently being held for hoarding purposes. By taking the totality of this demand and refocusing it on pre-2023 gold, the price of clean gold might trade at, say, $3,000 while the price of dirty gold trades at just $300.

On the other hand, the premium would remain low if the clean gold standards are poorly managed and lack credibility.

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Who would want to buy dirty gold?

Investors who are less concerned about the environment might be content to keep holding dirty gold kilo bars and 400-ounce bars. People who buy gold jewellery might not mind holding dirty gold either, since dirty gold necklaces will be cheaper than certified clean necklaces.

I suspect the main buyers of dirty gold would be manufacturers that use it for industrial purposes, like circuitry. Gold has excellent conductivity. It is also the most non-reactive of all metals, which means that unlike copper and silver it is resistant to corrosion & oxidization.

Given these advantages, manufacturers would love to use more of the yellow metal in their products. However, gold's high price prevents broader industrial usage of gold. The dominant group of buyers—hoarders & investors—keep gold's price perpetually high, thus pushing manufacturers out of the market. And so copper has become the most important metal in electronics. By diverting a large chunk of hoarding demand to a certain type of gold, clean gold, chip makers could finally get access to low-priced gold. Gold would displace copper and the overall quality of electronics products would improve.

Certain manufacturers that want to demonstrate a commitment to having sustainable supply chains (i.e. Apple?) would probably purchase clean gold, and so their products would be more expensive than those without clean gold.

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What about coins?

As I suggested earlier, mints such as the US Mint and Royal Canadian Mint would produce two streams of gold coins: clean coins and regular ones. They would buy clean gold feedstock from the LBMA's certified clean gold inventories. The mints would include branding on clean coins to certify their clean status. As for their regular coins, mints would continue to buy newly mined gold from miners.

I suspect that many gold coin buyers would default to the woke alternative. Say that Jack has $10,000 to invest in gold. He can either buy 4 clean Maples for $2500 each or 40 dirty Maples for $250 per ounce. At least with the clean option Jack can feel good he's doing the right thing. Either way, he ends up with the same nominal $10,000 in metal, and it's the nominal amount of metal that most gold investors care about, not the actual quantity of ounces. 

Of course, there are gold coin buyers who like to consume their gold (say like Scrooge McDuck) and prefer to get more bulk for their dollar. They will be happy to buy the dirty stuff.

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Gold laundering would be a big issue.

With clean gold trading at a premium to dirty gold, fraudsters would try to profit by converting gold mined in 2025 or 2026 into counterfeit gold bars with a 2016 or 2017 date, and then try to sneak the counterfeit bars through the LBMA's (or State Street's) verification process. These institutions would have to set up effective mechanisms for stopping counterfeit gold bars.

At the same time, the LBMA and State Street would have to find ways to ensure that they are not preventing legitimate pre-2023 bars from entering their systems. Central banks would probably account for a large proportion of pre-2023 bars. Going forward, their holdings would be a key source of clean gold.

Rogue gold coin manufacturers would buy mined gold at $250 an ounce and manufacture fake Maples or Eagles for $2500. Mints such as the Royal Canadian Mint and US Mint would have to introduce additional anti-counterfeiting measures into their manufacturing processes to guard against fake clean coins.

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There are plenty of other things that can be said about clean gold, but for now that's probably enough.

In sum, if a clean gold standard was carefully implemented and became popular with investors, it would synthesize many of the same effects of an outright ban on mining. By herding the gold investment community away from the newly-mined gold market, the amount of gold mining would fall, and so would associated environmental damage.

It would also correct a major defect of the gold market. Manufacturers who actually buy gold by the gram for use in their products have always had to compete with investors/speculators who aren't beholden to the same profit and loss calculation as a business. This is just silly. Disaggregating gold into two types corrects this. Investors & speculators can continue with their bets as before by focusing on the first type of gold, and it's clean to boot. And manufacturers finally get access to cheap type 2 gold. It's win-win.

Wednesday, September 2, 2020

Different bitcoins different prices


Not all bitcoins are the same. If someone steals 100 bitcoins from a cryptocurrency exchange and tries to sell them, they'll have to price them at a discount to the market price in order to compensate the buyer for the risk of laundering them. Different bitcoins different prices.

This isn't just a bitcoin phenomenon. There are two wholesale markets for banknotes, too. The legitimate one is comprised of banks, retailers, and cash-in-transit companies like Brinks that exchange notes at par. And the illegitimate one is made up of mob lawyers, drug dealers, and note brokers exchanging dirty notes at 20 or 30 cents on the dollar. Different dollars different prices.

You can find this same fractionalization everywhere: in electronics or prescription medicine or used cars. There is a licit and illicit price in each market.

But the difference between dirty and clean prices isn't the dichotomy that interests me in this post. Could we see a two-tiered market develop for clean bitcoins? In other words, could a situation arise in which Jerry's 100% legitimate bitcoin's are worth more than Elaine's 100% legitimate bitcoins?

I'd argue that the precedent already exists in the gold market.

Last month I wrote a quick explainer on the London Bullion Market Association, or LBMA, for CoinDesk. The LBMA is a standards-setting body for the gold market. It defines what constitutes a London "good delivery" gold bar and what doesn't. These standards include physical details like purity, weight, height, and appearance. Increasingly, the LBMA's standards are being stretched to include details about sourcing. Has the miner extracted the metal in an environmentally friendly and ethical way? Are they laundering money for Mexican drug lords?

Good delivery bars can only be stored in a handful of London-based vaults. A strict paper trail is maintained to ensure that nothing gets in (or out) of this walled-garden. The moment a bar is withdrawn from a London vault, it loses it's good delivery status.

This has the effect of creating a two-tiered licit gold market, one in which London gold is worth more than non-London gold.

Consider that the world's largest buyers congregate in London to trade gold. A 400-ounce gold bar fabricated by a refiner that doesn't have the LBMA's stamp of approval can't access the incredibly liquid London market. And so it won't be worth as much as an LBMA-approved 400-ounce bar. (No one wants to buy your metal if it can't be immediately on-sold in London.)

To be granted London "good delivery" status, an unapproved bar must go through a process of being anointed. That means bringing the bar to a refiner on the LBMA's approved refiner list. The refiner vets the bar owner to check for money laundering, much like a banker would. Only then can the bar be melted down and reformed into an entirely new and approved bar. But all of these steps are costly.

As my CoinDesk article suggests, we might one day see the same sort of fractionalization emerge in the bitcoin market. A core group of exchanges and custodians would begin to define what qualifies as a "good delivery" bitcoin. Standards would mostly apply to the provenance of bitcoins. Since the history of bitcoin transactions can be easily monitored, it is relatively easy to cast aspersions on certain flows of bitcoins, perhaps because they happen to pass through suspicious addresses or are  mixed by coin tumblers. (As Izabella Kaminska suggested a while back, bitcoin has a lien problem. Tim Swanson has been writing about this for a while, for instance in A Kimberly Process for Cryptocurrency.)

Should a bitcoin be withdrawn from this "walled garden" of approved exchanges and custodians it would fall out of the Bitcoin Marketing Association's "chain of custody" and, as such, would no longer have access to core liquid markets. And so unapproved bitcoins would be forced to trade in lower quality venues with lax vetting standards, and less liquidity.

An online retailer might not want to take the risk of selling their products for unapproved bitcoins (i.e. ones that come from non-vetted personal wallets). Sure, it might be possible for the retailer to accept non-approved flows with the intention of re-depositing them into the Bitcoin Marketing Association's system in order to get the Bitcoin Marketing Association price. But there would always be the risk of an unexpected blockade or freeze of a customer's unapproved bitcoins. And so retailers would ask their customers to only spend approved bitcoins straight from their Coinbase wallets.

By the way, the sort of LBMA-driven dichotomy that exists in gold (and could one day exist in bitcoin) does not exist in banknote markets. There is no such thing as a good & expensive $20 bill and a good but cheap $20 bill. Cash, as we say in the monetary biz, is pretty much fungible.

Why do we see a two-tiered gold market but just a single-tiered banknote market?

There are probably many reasons for this, but a big difference is the sorts of people that occupy each market. The gold market is populated by investors, the most dominant of which are large institutional investors and central banks. These big players do not want the risk of having their gold being tarnished in any way. They don't want their $50 million in gold bars to end up being fake, or subject to a court dispute, or frozen by law enforcement due to money laundering concerns. That's why the LBMA standards exist; to make gold safe for big institutional buyers.

But cash is different. Warren Buffett and Ray Dalio don't occupy this particular market. The market for coins and notes is dominated by regular people. Furthermore, banknotes are primarily used in small day-to-day retail purchases, not financial speculation. This sort of activity is not conducive to the emergence of a centralized marketing association. Cash transfers are done too quickly, and in small amounts, and by folks who don't have deep enough pockets to pay for verification.

The market for banknotes is literally everywhere (each corner store in town will accept them), whereas the market for gold tends to clump up in a certain specific physical locations. This centralization makes standardization easier.

Bitcoins are more like a gold bars than a banknotes. Let's face it, it's been ten years since bitcoin appeared on the scene and no one really use bitcoin it as money (just like they don't use gold as money). The majority of bitcoin demand is a demand to hoard the stuff for price exposure, much like the yellow metal. And like gold, the market for bitcoins has coagulated around exchanges. It's not an everywhere market, not like the market for banknotes.

So to sum up, the market for bitcoins is very much like that for gold. Given that a standardized gold market has evolved, I wouldn't be surprised to see the same happen to the bitcoin market, especially if big financial institutions start arriving.

Wednesday, August 26, 2020

18 things about Tether stablecoins


Before I start my list, a bit of introduction.

Tether is a stablecoin. It happens to be the most popular stablecoin in the world.

A stablecoin is a digital IOU that is implemented on a blockchain. In Tether's case, it takes the form of a U.S. dollar-denominated IOU implemented on the Ethereum blockchain. Tether holds U.S. dollars in a traditional bank account. It issues digital blockchain-based Tethers that are convertible into those bank account dollars at a 1:1 rate. This promise is what stabilizes them. And so a user can send some Tethers to another Tether user, say as payment, and neither party need worry about bitcoin-style price disruption.

If you didn't understand any of that, think of Tether as basically PayPal, except on a decentralized database instead of a centralized one.

Thoughts, facts, questions, and interesting tidbits in no particular order:


1. According to Coin Metrics, a financial data provider, Tether is now doing around $3.3 billion per day in transfer value. It just flipped bitcoin's daily volume of $2.94 billion.

2. PayPal did $222 billion in total payment volume last quarter. That's around $2.47 billion per day. So Tether at $2.94 billion is moving more value each day along its network than PayPal is (!).

3. There is a popular theory in the cryptocurrency community that expansions in the supply of Tether are being used to manipulate the price of bitcoin. I don't subscribe to this theory. It strikes me as far-fetched, much like the theories about gold price suppression.

4. U.S. citizens and residents are prohibited from using Tether's version the U.S. dollar (with one small exception).

Tether legal disclaimer [source]

5. Does anyone know who regulates Tether? (Yes, Tether Limited is regulated by the U.S's FinCEN. But who regulates Tether International Limited? Its terms of service says that it is based in the British Virgin Islands. But a search of the BVI's Financial Services Commission doesn't indicate that Tether International Limited has been registered as a money services business.)

6. According to a report by Chainalysis, a blockchain analytics company, Tether is probably being used to evade Chinese capital controls. Chainalysis estimates that $50 million Tethers leave East Asia each day.

7. One reason Tether is popular is because it doesn't collect information about ~99% of those who deal in Tethers. It only does due diligence on the minority who want to cash-out of Tethers (i.e. withdraw Tether dollars in a bank account) or cash-in to them (i.e. deposit dollars into Tethers via a bank account). So if you are content to just accept them and then pass them on, Tether shrugs. This makes Tether stablecoins an incredibly hands-off way to interact with digital U.S. dollars. (By the way, almost all stablecoin issuers adopt the same unknown-wallet-to-uknown-wallet policy as Tether.)

8. In its recent report on "so-called" stablecoins, the so-called Financial Action Task Force hinted that stablecoins must abide by the same diligence requirements as a bank. So I doubt that Tether's "hands-off" policy can last much longer.

9. This hands-offness attracts unsavory users. I've written before about MMM BSC, a global ponzi game that uses PAX stablecoins. (PAX is a smaller stablecoin). According to Coinmetrics, Tether stablecoins on Tron (a blockchain platform) are often used for "dividend schemes." However, I have not run across a single ransomware operator that uses Tether for ransom payments. Bitcoin (and to a lesser extent Monero) still dominate the ransom market.

10. Tether freezes a lot of addresses, according to Eric Wall. More than any other stablecoin.

11. I have never used Tether. (For the sake of experimentation I have tried PAX, a smaller U.S. dollar stablecoin).

12. The collapse of global interest rates since COVID-19's arrival has helped popularize stablecoins. A Tether stablecoin yields 0%. So post-collapse they have become more competitive with dollars in a bank account. Ironically, the collapse in rates also hurts stablecoin issuers. Issuers can't make as much interest on the reserves they hold to back their stablecoins. (More here).

13. Tether was initially launched as RealCoin in July 2014. It rebranded later that year. I speculated about the emergence of Tether-like instruments in 2013. I didn't call them stablecoins. I called them stable-value cryptocoins and stable-value crypto-currency. (Forgive my self-promotion).

I believe it was Vitalik Buterin who coined the term stablecoins?

14. The popularity of Tether hints at the dominance of the U.S. dollar. No one seems to be using euro, yen, or yuan stablecoins.

15. There are currently $13 billion worth of Tethers in circulation. There are currently around $31 billion PayPal dollars in existence (PayPal refers to these balances as "Funds payable and amounts due to customers").

PayPal Q2 2012 report [link]

16. Tether can't be used in... Singapore? (Also Cuba, North Korea, Iran, Syria, Venezuela, Crimea). Anyone know why?

17. It's common knowledge that the dollar-denominated assets that Tether holds to back Tether stablecoins are questionable. Shenanigans have occurred. (I wouldn't touch them. I wouldn't want family touching them.) But people still hold Tethers and deal in them. Why? Many institutions and trading outfits use Tethers as a bridging mechanism for arbitraging the price of cryptocurrencies across various exchanges. Given that Tether is their preferred medium for this, it speaks to the poor level of due diligence in the industry. It also speaks to the network effects enjoyed by first movers. So-called sophisticated crypto traders are using dodgy Tethers rather than safer but newer stablecoins because much of the liquidity has already attached itself to Tether. 

18. A big part of the cryptocurrency trading universe is denominated in Tethers, not actual U.S. dollars. So if Tether starts to collapse, cryptocurrency prices would actually hyperinflate. (Real cryptocurrency prices wouldn't budge.)

19. Tether has co-opted the unicode currency symbol for the Mongolian tugrik, ₮.

Feel free to add your own factoids in the comments.

Friday, August 21, 2020

The case for banning gold mining

The Kalgoorlie Super Pit Mine in Australia

Does the world need gold mining?

Let's think about what a world without farming look like. If all farming came to a stop, we'd soon use up all of our inventories of wheat, soy, rice, and vegetables. Mass starvation would rapidly ensue. A world without crude oil production wouldn't be much better. We have plenty of the stuff above-ground. But since oil products are destroyed in usage, we'd run out pretty quick. Society would grind to a halt.

But if gold mining were to suddenly stop, nothing bad would happen.

The unique thing about gold is that it doesn't get used up. The main way we consume the yellow metal is by storing it, say in vaults or by wearing it as jewellery. Compared to how we use an industrial metal like copper, this sort of usage is very safe. Copper parts in machinery, for instance, are dissipated by abrasion and wear. But gold just sits there, untouched.

Nor does gold depreciate. Unlike most materials, it is almost indestructible. Copper corrodes, steel rusts, wood rots, and concrete crumbles. But a gold coin from 200BC is still perfectly lustrous.

Nor does the yellow metal suffer from technological obsolescence. Gold keeps doing the same thing it has done for thousands of years.

And obviously we don't eat the stuff.

The upshot of all of this is that most of the gold that has ever been mined continues to exist in the form of bullion or jewellery. The World Gold Council estimates this amount to be around 190,000 tonnes. This above-ground stock of the metal dwarfs the amount of new mine production, which runs around 3,000 tonnes per year.

Were this 3,000 tonne trickle were to come to an end, we'd still have plenty of the yellow metal to meet our needs. The existing stock of gold is incredibly flexible and can repurposed into whatever form we want. Gold fillings can be melted down to mint coins, which can be recycled to produce circuits. Circuitry can be melted down to form bars, which can be melted down to gold fillings.

There is a second reason why we don't need new gold mining.

Our demand for most things is defined in terms of physical units. But our demand for gold is expressed in terms of dollars.

Let me give a better explanation for this difference. To make breakfast for a gathering of friends, say that I plan to get a package of bacon, a dozen eggs, and a litre of milk. When I arrive at the grocery store I discover that the price for these things is higher than I thought, and I can't afford everything on my list. It'll be a disappointing breakfast for my friends.

But our demand for gold is different. Say that I want to buy some gold to hold in a vault. It doesn't make a difference to me that the price is higher than I planned for. If the price is $1000, I'll buy 1 ounce. If it's risen to $2000 I'll buy 0.5 ounces. Either way I end up with the same $1000 worth of gold. I'm perfectly indifferent between these two states of the world.

Because our demand for gold is expressed in dollar amounts, there can never be a shortage of the stuff. If everyone on earth suddenly wakes up wanting to own twice as much gold as before, the price of gold can rise to whatever price is necessary to meet that demand. Not so with pork, or eggs, or milk. If everyone suddenly wants to eat twice as much pork, there's nothing that can satisfy that demand except for a huge ramp up in production.

So to reiterate, society doesn't need new gold mining. The stuff is virtually indestructible, and any increase in demand can be instantly satisfied by a rise in price, not new production.

By the way, I'd have a different opinion on this if we were still on a gold monetary standard. Under a gold standard, all goods & services prices are defined in terms of a fixed amount of gold. A steady stream of new gold from mines would help mute large fluctuations in the demand for gold, thus making the general level of consumer prices more stable. But ever since 1968 the gold link has been severed.

Now let's go onto the next issue. If we don't need new gold, why not just ban gold mining?

Mining imposes many costs on society. To begin with, mining is incredibly invasive. Pascua Lama, a project in Chile that has yet to be developed, originally envisioned relocating entire glaciers to get at the underlying gold formations. The Donlin mine in Alaska involves moving "one mountain to another." Clearing out mine sites destroy forests, wetlands, and displaces wildlife.

When rock is processed to retrieve gold, the uneconomic reminder, known as the tailings, must be kept in large reservoirs know as tailings ponds. Dangerous chemicals like cyanide are required to "leach" gold from rock. The breach of a tailings pond at the Mt Polley gold mine in British Columbia, Canada led to 10 million cubic metres of water contaminated with arsenic leaking into nearby lakes and rivers.

Mt Polley before and after a tailings pond leak

Earthworks, an environmental group, calculates that 20 tons of toxic waste are produced for every 0.333-ounce gold ring.

Finally, the various steps in producing gold—mining, milling, and smelting—create large amounts of green house gases, as does the associated usage of electricity to power a mine.

So to review, banning gold production won't hurt society—we don't need more of the stuff. To boot, we'd be getting rid of an activity that hurts the environment.

Yes, there are drawbacks to a ban, too.

Mining provides employment. Not only would a ban destroy the livelihood of hundreds of thousands of miners. All the related businesses that depend on the local gold mine, say restaurants or local retailers, would collapse.

To avoid mass dislocation, gold mining bans would have be carried out slowly. Perhaps existing mines could be allowed to operate until they are no longer economic, but gold prospecting, mine extensions, and new mines banned. These policies would have to be accompanied by large budgets for relocation and retraining. 

But even if dislocation could be managed, there remain other problems.

The production of drugs like cocaine is illegal, but this hasn't stopped drugs from being produced. The same applies to gold. No doubt production bans would be fairly effective in countries like Canada and the U.S., but what about Kazakhstan and Guyana?

Unfortunately, a ban on global gold mining could end up replacing relatively safe and clean gold production with dirtier and more dangerous types of mining. A small but significant chunk of global production is carried out by artisanal miners; family-run outfits that do not exist in an official capacity. Because they are small and agile, artisanal producers could more easily evade a ban. Unfortunately these black market producers are not likely to be held to the same environmental and labour standards as large multinational miners.

A ban on gold production could create a more general problem. Historically we have banned products that are dangerous to consumers, say like drugs. But in this case we'd be introducing a new set of criteria for instituting a ban; because some product serves no purpose. Maybe you think that zombie movies are a waste. Does that mean we should stop allowing producers to make new zombie films? This may be a door we don't wish to open.

So as you can see, banning gold production has merits and warts.

But in theory, the idea makes a lot of sense. If something is indestructible, and we only want dollar amounts of it rather than ounces, why the devil are we wasting time and resources producing it? As long as we can successfully shift gold mining communities to other forms of employment, then ending global gold production makes a lot of sense.

Tuesday, August 18, 2020

Bitcoin is an account, not a token



When economists talk about payments, they often make a distinction between token-based and account-based payment systems. In a recent post at the New York Fed's Liberty Street blog, Rodney Garratt & cowriters argue that new payments technologies like bitcoin and central bank digital currency may not fit into these traditional categories. Perhaps it's time for a reorg?

In an account-based system, some sort of database stores account information. For a payment to occur across this database the payer needs to prove that they own a spot in that database, and that this spot has sufficient funds.

With a token-based system there is no database. Instead, objects are used to pay (say banknotes or gold coins). The key feature of a token-based system is that the recipient must verify that the object is valid and not counterfeit.

In short, tokens involve identifying the object. Accounts involve identifying the individual.

Garratt et al argue that a digital currency such as bitcoin is a mix of the two, token and account. Bitcoin is an account-based system because some sort of "proof of identity," specifically a private key, is needed to transact. This puts bitcoin in the same category as a bank account, which also has a process for verifying the identity of users. (Instead of public key cryptography, bank customers must go through a due diligence process, and after that must produce a PIN.)

I think Garratt et al are right about bitcoin being an account-based system. But I don't think that bitcoin also qualifies as a token-based system.

Not a token

A token is an object. And objects can be counterfeited. That's why when Alice pays Bob a $20 note, Bob is responsible for carefully checking it.

Account-based systems don't suffer from counterfeiting problems. It's impossible for a Alice to pay Bob with fake dollars from her Wells Fargo account. Wells Fargo dollars aren't independent objects in the same way that banknotes are. They are entries in a well-secured database. The same goes for bitcoins. There is no way for Alice to make a fake bitcoin entry and send it to Bob.

In addition to counterfeitability, I'd argue that another key feature of a token is that it can be lost by one person, found by another, and then reused for payment. If Bob loses either his $20 banknote or his gold Krugerrand, Alice can find them and spend them.

But account-based systems don't have this feature. Wells Fargo dollars are database entries. It'd be impossible for Alice to lose a Wells Fargo database entry or Bob to find one and reuse it. And the same goes for bitcoins. Alice can't lose 0.2234 bitcoins, nor can Bob find Alice's 0.2234 bitcoins.

Gift cards: account or token?

What about gift cards, say like those iTunes cards that they sell at pharmacies?

Because gift cards come in physical form they may seem like tokens. But the card is just one element in an account-based system. A $20 iTunes balance exists in a database run by the gift card system operator, Apple. Whereas a $20 banknote can be used without the authorization of the central bank, an iTunes card has to be granted permission before it can initiate purchase. If the database entry to which an iTunes card is linked is empty, then a payment will be denied.

Like other account-based systems, counterfeiting isn't a problem with gift cards. Database entries can't be produced with an inkjet printer. (Sure, an iTunes card can be lost and reused by the finder. And so it seems like it should be classified as a token. But that's only because the "key word" or "password" is literally baked onto the card. Losing an iTunes card is like losing one's private bitcoin key.)

Bitcoins and gift cards can be turned into tokens

There is an interesting situation in which gift cards or bitcoins can be converted from account-based systems into token-based systems.

Instead of using her $20 banknote to pay Bob, Alice may choose to pay Bob by passing him a $20 iTunes card. Or maybe she gives him a physical Opendime hardware wallet that holds $20 in bitcoin. Bob could in turn pass these devices on to Charlie, to whom he owes $20, and Charlie on to Dave, etc.


In both cases, accounts are being repurposed as tokens. What is happening is the physical object, or key, that provides access to underlying bitcoin or gift card database entries is being moved from one person to another. But the actual database entries to which the Opendime and iTunes card are linked are not being updated.

Bob will have to treat both of these proffered instruments like cash. He'd be worried about counterfeits, and would want to verify that neither the gift card nor the Opendime device are fake.

Let's vizualize all of this into a table:


The table suggests that bitcoin exists in a totally different category than a banknote (unless those bitcoins are embodied in the form of an Opendime device). You'll also notice that the table differentiates between open accounts and closed ones. Let's get into that next...

Bitcoin and Wells Fargo are different types of accounts-based systems

If bitcoin qualifies as an account-based system, it is certainly different from Wells Fargo's system. I'd argue that Wells Fargo operates a "closed account" system while Bitcoin functions as an "open account" system. The key feature of an open system is that anyone can get an account. As Jerry Brito would put it, they are permissionless. A passport or driver's license isn't required to gain access, so even fraudsters can climb aboard.

Gift cards, non-reloadable prepaid cards (like Vanilla cards), and e-gold (a 1990-2000s era payments system that didn't require people to use real names) are also open account systems. Anyone can self-initiate account opening and start to make payments. No one gets kicked off. (We could further differentiate between centralized and decentralized open account systems, with gift cards being the former and bitcoin the latter.)

What qualifies something as a closed account system is that not just anyone can get access. Want to use a Wells Fargo account for making payments? You'll have to make it through Wells Fargo's application process, which involves giving up plenty of personal information. And only when a Wells Fargo employee has opened an account can payments be made.

Turning bitcoins, gold, and cash into closed account systems

Incidentally, it's also possible to convert tokens and open accounts into closed accounts. The London Bullion Market Association (LBMA) manages a walled garden of gold bars. Each bar is carefully vetted prior to entry into the system, and once in the system all movements are tracked by monitoring serial numbers. LMBA gold has ceased to be a token and has become a closed account. (I recently wrote about the LBMA system for Coindesk.)

Central bans could do the same with cash. They could set up an online bank note registry, and all cash users would be required to sign-up and record the serial numbers of note each time they receive a new one.

As for bitcoin, many people already keep their bitcoin in at regulated services like Coinbase that require customer ID. One day it may only be possible to send bitcoins from one regulated service to another, in which case a big chunk of the Bitcoin network will have become a closed account system, not an open one.

Why does all this matter?

Specialists need to be able to have conversations about their subject matter. Categorization is one of the ways to make these conversations flow without chaos. Are the categories we use for conversing on the topic of the economics of payments still sufficient? The world has changed. We've got new entrants like bitcoin and central bank digital currency. Garratt et al suggest that aging categories can "slow down progress in understanding intrinsic differences between the growing set of digital payment options and technologies."

But this case I think the old taxonomy are still useful, albeit with some tweaks.



P.S. Lawyers, regulators, users, and developers will all have different taxonomies for payments. Inter-taxonomic conversations are difficult, since a single term can mean something totally different. So stay within your taxonomy to avoid confusion.

Friday, July 31, 2020

How the pandemic has clogged the global economy with paper currency


The outbreak of Covid-19 has caused a global increase in the amount of cash in the economy. I think I've got a pretty neat explanation for why.

But before I tell you what it is, let me show what the cash build-up looks like. Here's what has happened to banknotes in circulation in Canada so far in 2020:

Meanwhile, here is the US:

And here is the UK:
Each chart shows an unusual increase in banknotes in the economy starting in March or April, when the pandemic first hit western countries. These cash bulges show no signs of shrinking. And they are quite big. In the case of the U.S., I'd estimate that there are $150 billion extra paper dollars in circulation thanks to the virus.

I recently came up with a surprising explanation for why this is happening. But before we get to it, we need to review what determines the amount of cash held in the economy. Here's an analogy. Think about how the water level in a reservoir might rise. There are two ways this can happen. More water can run into the reservoir, or less water can flow out. (Conversely, the water level can fall when either less water enters, or more is withdrawn.)

The same principle applies to the amount of cash held in the economy. If more people are taking cash out from ATMs and banks then the amount of cash in the economy will grow. But the amount of banknotes in the economy can also grow without a rise in withdrawals. That can happen when the public (i.e. individuals & businesses) returns less of the stuff than before to ATMs and banks. So more of it stays floating around in the economy.

Now, I must confess that in previous blog posts and tweets I had assumed that the big increase in cash-in-circulation during the pandemic was due to an increase in withdrawals. People were worried about the virus, I thought, so they wanted to take more banknotes out of their bank accounts and hold it under their mattresses. "Cash restocking makes sense in an emergency like the one we are living through," I wrote back in April. And here: "The coronavirus reminds us of the fragility in our infrastructure. And so we rebuild some of our banknote balances."

But now I think that I was wrong. The big increase in cash-in-circulation is not due to an increase in withdrawals of cash. Sure, some people are taking out a few more $50s or $100s to hold under their mattress. But with the virus shutting down the economy, most of us are making less purchases than before. The few transactions that we continue to make tend to be digital, say like buying from Amazon with a card. The net effect is that since March we have been withdrawing far less cash than normal.

If so, then why has the level of cash in the economy jumped? The only explanation is that there is much less cash being returned to banks and ATMs. Businesses and individuals simply aren't redepositing their banknotes. There's some sort of clog or blockade that is gumming up the system and preventing a regular flow of returns. I'll try and explain the precise nature of this clog, but first lets look at some data that confirms that returns of cash have dried up.

The European Central Bank (ECB) is unique. Most central banks only provide public data on the net amount of cash that is in circulation. But the ECB goes the extra step and offers data on both the flow of banknotes being issued into the economy and the flow being withdrawn from the economy. And so we can actually see which half of the equation is responsible for the big jump in cash: more withdrawals or less returns.

As you can see, Europe has seen a large and anomalous jump in cash-in-circulation in 2020, just like Canada, the US, and UK. I've charted this below:


Now let's see what the ECB's disaggregated data has to say:


In general, withdrawals of euro banknotes (the blue line) has exceeded returns (the orange line) from 2007 to 2020. That's why the amount of cash in the European economy has generally increased over time. During the 2008 credit crisis, there was a big jump in withdrawals, no doubt to worries about the safety of the banking system. But during the pandemic, cash withdrawals (blue line) have actually fallen, not increased. In fact, the level of withdrawals is at its lowest point in over a decade!

Returns of cash (orange line) have plunged by even more than withdrawals. They are at their lowest level ever!

So what does this mean? Thanks to the pandemic, European individuals & businesses have become less interested in taking cash out of the bank. But they are even less interested in returning cash to the bank. It is this outsized collapse in returns, the orange line, that is causing the big build-up in euro banknotes in circulation.

For those who like analogies, let's revisit our reservoir imagery for a moment. The amount of water (i.e. cash) flowing into the reservoir (i.e. the economy) has slowed to a trickle. Normally this trickle would lead to a fall in the water level. But because even fewer people are removing water (i.e. doing cash returns) from the reservoir, the incoming trickle is sufficient to push the water level higher.

I think there's a good chance that what is happening in Europe is happening in the U.S., Canada, and U.K. too. Thanks to the virus, no one is redepositing their banknotes. But I'd have to see the data to be sure.

Now we can finally get to my theory for what is clogging up the system. The peculiar feature we need to explain is people are so much less willing (or able) to return their notes during the pandemic than they are willing to withdraw them. Or put differently, why did the orange line fall so much more dramatically than the blue line did? It suggests some sort of asymmetry in people's usage of cash. My theory is that this asymmetry can be found in the nature of the black market, illegal drug markets, the mob, the underground economy, etc.

The specific asymmetry is this: it is quite easy for a drug buyer to withdraw $200 from an ATM to buy heroin or cocaine. Banks don't surveil people who are taking out cash. But it is far more complicated for a drug seller to redeposit that $200. Redeposits are surveiled. To get banknotes back into the system a crook has to launder them, say be sneakily mixing the drug money with legitimate cash earned by cooperating cash-intensive businesses like restaurants, casinos, or cornerstores.

Let's work through how this specific asymmetry has collided with the pandemic. It's unlikely that drug users have stopped buying drugs during the pandemic. (Maybe people are buying even more drugs? Thanks to shut downs, there's not much to do!) So the flow of cash from a drug users' ATMs to a drug dealers' pockets has not slowed at all during the pandemic.

But the network of restaurants and other businesses that drug dealers rely on to launder their funds have all shut down thanks to virus fears and lockdowns. These closures would have put drug dealers, crooks, the mob, etc. in a tough position. Throughout the pandemic they have been accumulating ever more cash from drug using customers, with no place to offload it.

So to sum up, the big increase in cash in the economies of Canada, Europe, US, and the UK is probably being driven by an unwanted accumulation of cash by crooks. Their regular money laundering arrangements aren't functioning.

I don't have any personal experience with being a criminal. But it's fun to speculate about what their lives have been like during the pandemic. The Tony Sopranos, Walter Whites, and Stringer Bells of the world are currently scrambling around for safe places to store their ever burgeoning stores of physical cash. In their houses, at a warehouse storage unit, or at a bank.

And since they can't convert their cash hoards into spendable money in a bank account, I'd imagine these crooks are having problems paying legitimate bills like mortgage payments and the cost of sending their kids to posh schools. With criminal enterprise handling so much extra cash, I'd also imagine that law enforcement agencies are seizing record amounts of cash via civil forfeiture. We could also be seeing a big jump in gang warfare as competing drug outfits raid each other for cash. To recover all of these extra costs of doing business, criminals are probably jacking up drug prices. Yep, I'd imagine it's not an easy time to be a criminal.

As the pandemic subsides and restaurants and other confederate businesses start to open, criminals will be able to restart their money laundering operations. But they won't be able to return their entire accumulated hoard at once. If they were to do so, the cash receipts of the businesses they are using for laundering would stick out, potentially drawing the attention of the tax authority and law enforcement. No, they'll have to slowly reintroduce their dirty money.

Which means the big global jump in banknotes that I illustrated in my first set of charts will take much longer to be worked off than it was accumulated.



PS: I wonder if we can get some other good insights from the data, specifically about the size of the underground economy. Looking at my topmost chart, I'd estimate that the amount of cash in the Canadian economy is about $6 billion higher than it would otherwise be. Let's say that this bulge is entirely due to criminals being unable to launder their drug proceeds. We know Canada has 32 million adults. So Canadians have spent $6 billion on illegal drugs since the pandemic began, or around $200 per adult. That's about $12 billion a year. Seems reasonable, no? (Yes, I am making a load of assumptions here.)  

Tuesday, July 21, 2020

Pennies as state failure


We can all think of examples of state failure. The most obvious include the inability to protect citizens from criminals, failure to provide drinkable water, and incapacity to cope with a public health crisis like COVID-19. I would argue that the ongoing existence of the penny within a nation's borders is another example of state failure.

The poster child for this particular example of state failure is the U.S. and its Lincoln penny. Many (though not all) developed nations have already rid themselves of their lowest denomination coin. (Well-run New Zealand has managed to cancel two of them, the penny in 1989 and the nickel in 2006!) My own country, Canada, was a disappointing failure on this front. But in 2012 we worked up our resolve and put an end to our orange one-cent discs.

In this post I'm going to explore why this particular example of state failure continues to plague the U.S. 

But first, let me make the argument for why pennies constitute a failure of the state.

Any government that still provides pennies is hurting its citizens

Most examples of state failure occur when the government doesn't provide a service or poorly provides one. In the case of the penny, the U.S. Mint, is ably providing us with a service, pennies. But this particular service is a frivolous one, sort of like offering free high fives or back slaps.

Actually, it's worse than silly. Pennies impose a tiny burden on each given individual. But when summed up across the entire population, each of those tiny burdens becomes a huge societal inconvenience. 

Let's take a moment to explore the penny supply chain. The U.S. Mint allocates a large chunk of its manpower and resources to producing pennies, as if these precious little discs were some sort of vital national service. Of the 4.9 billion coins the Mint has produced in 2020, 55% have been pennies.

Fresh pennies then get transported to banks. Stores dutifully buy the tiny discs from banks so that they can give them out as change to customers. But pennies are of too little value to be of any use to us shoppers. We mostly throw them in the garbage or forget them in jars. The conscientious among us redeposit them into the system using Coinstar machines or at the bank. This penny charade goes on and on and on, every hour of the day.

It's a costly charade. The U.S. Mint expends 1.6 cents for each penny it produces. But that's only a small part of the waste. Large quantities of time and resources are expended by all of us—banks, shops, transport companies, consumers—in moving pennies, storing them, counting them, sorting them, and moving them again.

Get rid of the penny and this whole charade ends. Everyone can stop pretending they are providing and/or enjoying an important public service.

So why hasn't the U.S. managed to exorcise itself of the penny? There are two theories. The most popular one is corporate capture. I'll explore that one first. My own personal theory, which I'll get into after, is American monetary populism. This populism gets in the way of the most basic of monetary reforms. (The two theories aren't mutually exclusive.)

The corporate capture theory of the penny

If you explore the oral history of the penny, you quickly learn about the penny lobby. Tennessee-based Jarden Zinc Products (recently rebranded as ARTAZN) is one of the largest producers of coin blanks in the world. Jarden is owned by One Rock Capital Partners, a private equity firm. Its main customer is the U.S. Mint, which buys and converts Jarden's zinc blanks into pennies.

We can dig into the U.S. Mint's financial statements get a good idea how much Jarden earns from the penny. In 2019 the U.S. Mint's costs of goods sold for pennies came out to around $124.9 million (2018: $145.7 million). I get that from the Mint's 2019 Annual Report (see screenshot below with yellow highlights). As the sole supplier of one-cent blanks to the Mint, Jarden Zinc Products gets most (if not all) of this $124 million stream of income. That's a big contract!

Source: US Mint 2019 Annual Report

Jarden has spent decades lobbying Congress to keep the penny in circulation. Below are its annual lobbying expenses going back to 2006, which I get from OpenSecrets. As you can see, Jarden paid its lobbyist, one Mark Weller, $120,000 in 2019. So far it has paid him $50,000 in 2002 2020. That doesn't seem like a bad investment if you want to protect a $124 million revenue stream.

Data from OpenSecrets

Below I've screenshotted a list of all the issues that Mark Weller has addressed in the first quarter of 2020 on behalf of Jarden. Most glaringly, he lobbied the Senate, Treasury, and House of Representatives on "issues related to the one cent coin." This issue consistently appears in each quarterly lobbying report going back to as early as 2009.

Another interesting item on Jarden's list of issues is the Payment Choice Act of 2019, which if passed would oblige retailers to always accept cash. No doubt Jarden is a big supporter of this particular bit of legislation; millions of retailers and banks would be forced to continue stocking one-cent coins, and that would mean more profit for Jarden shareholders.

Lobbying activity for Jarden Zinc in the first quarter of 2020. Data from OpenSecrets.

Nor is Jarden the only corporate culprit.

Coinstar, the company which provides Americans with ubiquitous coin-cashing machines, also benefits from the penny. Earlier this year Coinstar lobbied the government on both the Payment Choice Act of 2019 and the Cash Always Should be Honored Act, or CASH Act, which would make it unlawful for any physical retail establishment to refuse to accept cash as payment. Coinstar also regularly lobbies law makers on "issues related to minting and coinage." I'm going to assume this has something to do with keeping the penny and nickel in circulation, and perhaps converting the paper dollar into a coin. (Note that Coinstar's corporate name was changed to Outerwall in 2013).

Below is a chart showing how much Outerwall (i.e. Coinstar) has paid to its lobbyist going back to 2014.

Coinstar is owned by Outerwall Inc. Data is from Opensecrets

So according to the corporate capture theory, companies like Jarden Zinc Products and Coinstar have managed to twist the legislative process to serve their own agenda.

I should point out that a counter-lobby exists. Citizens to Retire the Penny is an anti-penny group run by MIT physics professor Jeff Gore. Here is its website. But according to the corporate capture theory of the penny, heroes like Gore lack the resources and expertise to out-muscle a slick Washington lobbyist like Mark Weller. The set of groups who are harmed by the penny—banks, citizens, shops—are too diffuse to provide much of a push-back.  And thus the final result is state failure. The U.S. citizenry is being mis-served by its penny-issuing government.

Just because I've shown numbers proving the existence of the penny lobby doesn't mean that the U.S.'s failure to remove the penny is necessarily a result of lobbying. We need more to complete the picture.

After all, we also have lobbyists up here in Canada. And we Canadians still managed to get rid of the penny. Australia, New Zealand, and Singapore also have lobbyists, but none of those fine countries have pennies anymore. To complete the story we need to be able to show that U.S. policy makers are more beholden to special interests than policy makers in other countries. And if so, that would explain why the U.S. is stuck with its orange burden, but the rest of us aren't. But I'm not an expert on differences in national lobbying, so I'll defer on this topic. Anyone have any good insights into this?

Now let's get to our second theory: monetary populism.

The monetary populist theory of the penny

I've spent about ten years writing about both the Canadian and U.S. monetary systems. And one of the consistent differences between the two countries is that Americans of all backgrounds have strong opinions about monetary issues. We Canadians generally don't express much interest on the topic of money and central banking.

I think it's great that Americans get so involved in these issues. Americans are critical and curious and want to know what their central bank, the Federal Reserve, is up to. Canadians' lack of engagement sometimes worries me. To ensure that institutions like the Bank of Canada are serving Canadians, we need to be constantly auditing and debating everything that they do.

Let me offer an anecdote. During the 2007-08 credit crisis I was indirectly involved in the Bank of Canada Act being updated. To help cope with the credit crisis, it was deemed that the Bank of Canada needed to be able to buy a wider range of securities than the law permitted it to. Even though Canada had a minority government at the time, the requisite legislation was quickly shepherded through various committees and then onto the floor of Parliament. Voila, with almost no fuss the Bank of Canada Act was updated and the Bank could buy more assets. I recall press coverage being minimal.

The same process in the U.S. would have attracted massive amounts of press coverage. Think tanks from all parts of the spectrum would have chimed in. The political sniping between Republicans and Democrats would have been loud and vigorous.

If Americans hold a wide range of views on monetary issues, many of these views are anti-establishment. I'm thinking the End the Fed movement in particular. (There is no equivalent End the Bank of Canada movement.) We Canadians tend to be more trusting of our monetary institutions and the elites that run them.

But American skepticism about monetary institutions often slides into knee-jerk conspiracy theories. And that's where I prefer wishy-washy Canadians and their lack of engagement. Whereas there are umpteen U.S. monetary conspiracy theories, there are almost no Canadian ones.

For instance, American monetary conspiracy theorists are currently wildly excited about the national coin shortage. Due to a number of reasons (which I go into here, and Will Luther explores here) there are not enough coins to meet public demand. This shortage is temporary and unplanned. But American monetary conspiracy theorists have reworked this incident into some sort of coordinated effort by the powers-that-be to force Americans onto a cashless digital dollar and ultimately, into subservience to a one world government.

Here is Twitter:  

And here is Facebook:

Source

Or here. I could provide many more examples. The coin shortage conspiracy theory has gone viral.

And so now I can finish off my theory. A society with a broad range of opinions about the monetary system (many of which are erroneous conspiracies and lies) is going to be much harder to change than a society that is neutral or uninterested about the monetary system. In the U.S., a fix as simple and smart as removing the penny will inevitably be misinterpreted (often willfully so) by crowds of monetary populists. And so any wise bureaucrat or legislator who wants to remove the penny will have to expend huge amounts of extra time combating misinformation. So maybe they won't bother.

And thus the state has failed Americans, and they are stuck with the penny. But we trusting (and perhaps naive) Canadians have been saved.



PS: In writing this I forgot to mention my last theory for the U.S. penny. American monetary experts tend to be inward-looking. Foreign monetary experts tend to be much more outward-looking. That is, an American analyst will generally know a lot about the Federal Reserve, but not much about the rest of the world's monetary institutions. But a foreign expert will generally be much more bilingual with respect to monetary systems. As a Canadian, for instance, I'm forced to know a lot about both my own monetary institutions and a list of American ones. A Swede monetary analyst is likely to be trilingual: comfortable with the Riksbank (Sweden's central bank), the European Central Bank, and the U.S. Federal Reserve. 

I worry that this inwardness leads to an incapacity on the part of the U.S. to learn from the successes of other monetary systems. The following nations have rid themselves of their lowest monetary unit: Canada, Australia, New Zealand, Switzerland, Singapore, Finland, Netherlands, Italy, Belgium, Ireland, Sweden, Norway, and more. That's a lot of playbooks to draw from. But many Americans won't know about this--they're too focused on themselves.