Wednesday, November 28, 2018

No, Ohio isn't accepting bitcoin tax payments

Anthony Pompliano, or Pomp, is at it again. Some of you may recall his odd claims about bitcoin adoption in Argentina, which I took apart here. Well, the following tweet wandered onto my twitter stream a couple of days ago.


For more, here is the Wall Street Journal.

So let's get this straight. The Ohio state government is not accepting bitcoin as payment for taxes. Rather, it is sponsoring a gateway that allows business owners to offload their bitcoins on the market in the moments prior to tax settlement. Now that actual dollars having been obtained, the tax obligation can now be settled. Take a look at the FAQ at ohiocrypto.com.
"At no point will the Treasurer’s office hold cryptocurrency. Payments made on OhioCrypto.com, through our third party cryptocurrency payment processor partner BitPay, are immediately converted to USD before being deposited into a state account."
Here's an example of how this might work. Let's say an Ohio business owner has to pay $10,000 in taxes. By logging into ohiocrypto.com, she can sell $10,000 worth of bitcoins to a payments processor called BitPay. BitPay in turn quickly sells those bitcoins for the requisite amount of dollars on a bitcoin exchange like Coinbase, and then forwards the $10,000 (in fiat) to the State of Ohio. Dollars, not bitcoins, are being accepted for taxes.

Ohio's announcement is not a big deal, certainly not one deserving of a WHOA. In addition to bitcoin, there are all sorts of assets that we taxpayers can offload in the moments before settling our tax bill. Once we know how much we owe, we can sell an appropriate amount of Tesla shares, then forward the dollar proceeds to the state. This sort of at-the-last-second sale is exactly what is happening with ohiocrypto.com, except an intermediary—BitPay—has been introduced to expedite the final step. We can do the same with gold, or silver, or property. Heck, using Pomp's definition we can even pay our taxes with an old IKEA sofa. Quickly sell the sofa at a low price on kijiji, deposit the cash, then settle the tax bill with an ACH payment to the government. The whole process won't take longer than 45 minutes.We don't even need to pay an intermediary like BitPay to process it.

The sad thing is that ohiocrypto.com is a big waste of taxpayer funds. Only a handful of businesses are ever going to use it. Say that our Ohio business owner has some dollars in her bank account as well as some bitcoin. She owes the state $10,000. According to the FAQ, the fee for going the Bitcoin route is 1%, which means she'll pay a fee of $100. Meanwhile, an ACH payment is free. Unless she has some sort of soft spot for paying with bitcoin, a quick and simple calculation means the she will never opt to use ohiocrypto.com, preferring to use old-fashioned but free ACH.

I'm being generous with my example. I've assumed that our business owner already happens to have enough bitcoin on hand to send her payment to ohiocrypto.com. But if she doesn't (which is likely to be the case), then that only multiplies the unlikelihood of her ever going via Ohio's new bitcoin route. To fund her $10,000 payment to ohiocrypto.com, she'll first have to endure the hassle and expense of acquiring enough bitcoins ahead of time. Given that she must still incur BitPay's 1% fee to settle her taxes, its hard to imagine her ever bothering to embark on such a costly chain of transactions.

Don't blame BitPay for the high fee. It charges 1% because dealing in bitcoin is a nuisance. Not only must BitPay recoup the trading costs that it incurs by selling our business women's $10,000 worth of bitcoins (both commission and slippage), but in the time between accepting her submission and making the trade it must cope with bitcoin's volatility. BitPay is just trying to get by.

Why is Ohio going through with this project? Ohio Treasurer Josh Mandel, who is behind the effort, has this to say: "Around 2014, I developed an interest in crypto and now I consider myself a crypto enthusiast." Right. This project seems more to me like a fanboy's devotion to the cause than a genuine attempt to help the Ohioan taxpayer.

Back to Pomp. To end his tweet, he proclaims that the "virus is spreading." Not at all. A well-designed payment option will literally drag people in because it is so incredibly useful. This ain't it, Pomp. Not only is Ohio not accepting bitcoins (no doubt they are too volatile), but it is unlikely that Ohio businesses will adopt ohiocrypto.com. Ten years into Satoshi Nakamoto's payments experiment, it still hasn't succeeded in pulling in mainstream payees and payors. Let's face it. Bitcoin is just not that great of a payments system.



...which isn't to say that bitcoin hasn't been successful. What Nakamoto didn't realize at the time is that he wasn't creating decentralized cash. Rather, he was creating what would eventually become one of the world's most popular decentralized financial games. Bitcoin is in the same category as the lottery or poker, not Visa or cash. If you think about bitcoin this way, you'll see why it is silly to set up payments gateways like ohiocrypto.com. If you were to offer someone the opportunity to buy $1 worth of goods with a $1 lottery ticket, they'd laugh at you. To a lottery player, their lottery ticket is their potential salvation, their route to becoming a millionaire. To use it to buy stuff would be sacrilegious. The same goes for bitcoin. People don't want to waste their prized bitcoins on buying stuff or making tax payments. No, their bitcoins are their ticket to riches.

Tuesday, November 13, 2018

The demonetization gap



Two years ago, Indian PM Narendra Modi suddenly demonetized all of the nation's 1000 and 500 banknotes. His stated goal was to exact justice on all those holding large amount of dubiously-earned cash. But since these two denominations constituted around 85% of India's currency supply, the demonetization immediately threw the entire nation into chaos.

After suffering from a nine-month note shortage, enough new notes were printed to meet India's demand for cash. But in the interim, what had happened to Indians' demand for cash? Did their experience with demonetization lead them to hold less cash than before, or did they simply revert to their pre-demonetization habits and patterns? I wrote an article in September 2017 dealing with these questions. With another year having passed we now have more data—so I'm going to provide quick update.

My claim is that a demonetization gap continues to exists. This gap is evidence that the cancellation of 1000 and 500s has had an enduring effect on Indians' behaviour surrounding cash.

To measure the gap, we need to compare the evolution of India's cash supply to the path it would have taken in a world in which Modi's demonetization never occurred. We know that the supply of rupee banknotes grew at an average rate of around 12.3% from 2011 to 2016, and on the eve of demonetization there were around 17.5 trillion in banknotes and coins in circulation. Taking these numbers and extrapolating forward, November 2018's cash-in-circulation count would have clocked in at around 21.5 trillion rupees had the demonetization not occurred. But in our actual world, the one where demonetization occurred, India's cash count registers at just 19.5 trillion rupees.

So thanks to demonetization, Indians are holding around 2 trillion fewer paper rupees than they otherwise would have. I've illustrated the demonetization gap below:

What sort of assumptions do we need to make in order for the demonetization gap to be zero? Let's say that demonetization had never occurred. To get from a currency stock of 17.5 trillion in November 2016 to 19.5 trillion by November 2018, we need to assume an absurdly low 6% growth rate for the stock of currency stock. I doubt India has ever experienced such a slow growth rate in cash-in-circulation. So while you can quibble with the size of the gap, I think it's undeniable that some sort of gap exists i.e. demonetization has had long lasting effects on cash holdings.

There are two potential explanations for why a demonetization gap exists. My guess is that both are to some extent true, although as time passes the influence of the second will tend to disappear:

1. Demonetization might have had a permanent effect on Indians' taste for cash. Prior to demonetization, a money launderer might typically have built up an inventory of 100 lakh (US$135,0000) worth of banknotes before laundering them. But the demonetization frightened him, so now he launders his ill-gotten gains whenever he holds just 50 lakh worth of notes.

Or maybe a family that typically conducted most of their day-to-day transactions in cash opened a bank account during demonetization so that they could deposit their notes. And now they've fallen into the habit of paying for half their family expenses with cash, and the other half with debit cards.

These sorts of changes to transactions preferences would get expressed in the nation's overall stock of notes by a reduction relative to trend.

2. Demonetization might have caused large and lasting damage to the informal sector of the Indian economy. With 85% of the nation's money stuck suddenly came unusable, and so many businesses dependent on cash, these businesses may have been forced to go under. With informal production cratering, fewer banknotes would be required for transactions purpose than would otherwise be the case. Over the long term, however, one would expect these sectors to rebuild, any drag they had once placed on cash demand being removed.

If Indian's taste for cash changed, how might these new tastes have manifested themselves? Did Indians swap cash for deposits in the regulated banking system or did they simply swap one form of anonymous "black money" for another (i.e. cash for gold, diamonds, real estate)? In my post from last September I found some interesting charts. I'm going to update them below.


As the chart above illustrates, the number of point-of-sale (POS) terminals installed has experienced a one-time shot to the arm after the November 2016 demonetization announcement.


The second chart shows that the value of POS transactions using debit and credit cards moved to a new and higher plateau.


The last chart shows the growth in value transacted using mobile wallets. Demonetization gave mobile wallet usage a quick shot to the arm, but it is difficult to determine if growth stayed above trend in 2017-18 or below. Given that mobile wallets are recent and started from a very low base, usage had already been growing very fast before demonetization.

In any case, I think the charts provide at least some evidence that the shift out of cash has been captured by digital finance.

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The existence of a demonetization gap does not mean that Modi's effort was a success. If someone comes up with a great monetary innovation, expect it to be quickly copied. Polymer banknotes, real-time gross settlement systems, and inflation targeting are all examples of monetary technologies that have spread from their original adopter to the rest of the world. But not a single nation has copied India's demonetization. I would be surprised if any ever do. The costs imposed by the event—lost labour time, foregone transactions, chaos—were all too apparent, and its benefits dubious.

That being said, I sympathize with the intuition that was at the core of Modi's demonetization. Let's face it, plenty of people use cash as a way to avoid taxes. These cheats force everyone else to pay more than their fair share for shared infrastructure. It would be nice if there was a way to rebalance the load by taking back resources lost to the cheats. A classic way to fix this problem is to have the tax department hire more inspectors. An alternative is to design the nation's cash system in a way that corrects for any unfairness. Modi's demonetization is an example of the second approach, a massive cash dragnet designed to flush out cheats.

But it was an incredibly clumsy effort. The tricky thing with cash is that it is simultaneously a vessel for tax evasion for a few cheats and also a vital monetary fluid for the many. Punishing the first group means that the second will also be hurt. If the costs incurred by the second group are too high, then the calculus behind the whole effort fails.

Modi's demonetization tried to lessen the blast radius by targeting users of large denomination 500 and 1000 notes while leaving users of the 10, 20, 50, 100, and 200 untouched. The motivation behind this was that presumably large tax cheats will concentrate their cash holdings in higher denomination notes, while regular note users will tend to concentrate in the lower denominations. But even with this filter in place, the 500 and 1000 were so widely held by Indians that the demonetization of these denominations forced a large proportion of the population to endure massive lineups for weeks. Retail trade ground to a halt.

Over the last two years I suggested a few ideas that would have improved the effectiveness of Modi's demonetization. Instead of targeting all 500s and 1000 notes, demonetizing notes by serial number would have resulted in a much smaller blast radius. Rather than withdrawing 500s and 1000s, it would have been easier to overstamp them with stickers, and then slowly withdraw these overstamped notes over time. This would have helped prevent massive cash shortages.

But even after these modifications, demonetization is too blunt of a tool to effectively solve the complicated inequities arising from cash-based tax evasion. So should Indians (and the rest of us too) simply live with these imperfections, accepting unfairness as an acceptable cost of maintaining cash systems?

Maybe not. In his paper Taxing Cash, Ilan Benshalom has suggested a less invasive technique for reclaiming resources from cash-using tax evaders. Rather than demonetizing all 500 and 1000s, Modi could have introduced a recurring withdrawal fee of 10 for each 500 note and a 20 rupee fee on each 1000 note.

Imagine that Rohit needs to pay Indira 10 lakh. The two can avoid taxes if they agree to transact using cash rather than making a digital payment. So Rohit withdraws one thousand 1000 bills from his bank. He incurs a fee of 20,000 (20 for each note), the bank forwarding the full amount to the government. Rohit might consider avoiding the withdrawal tax by withdrawing 50s and 100s (which don't incur fees), but he is unlikely to go this route since 10 lakh in small denomination notes would be terribly awkward.

The upshot is that Indian tax payers would get 20,000 in compensation for Rohit and Indira's evasion of taxes. Compared to Modi's demonetization, the blast radius of a large denomination withdrawal tax is much smaller. Regular Indians could have easily continued about their business using untaxed 100s or migrating to digital payments. It sounds promising, but after Modi's explosive demonetization, Indians are probably much less open to new monetary experiments, and who can blame them.



There are several other ways to visualize Indian demand for cash over time. For instance, here is the cash-to-GDP ratio:



The idea here is that for each unit of GDP, some amount of cash is used as means of circulating production. (Note: While the cash-in-circulation numbers are current, 2018 Q2 nominal GDP has still not been published. I estimated it by assuming 11.5% nominal growth, the average growth rate over the last few years.)

Vivek Dehejia and Rupa Subramanya measure the ratio of cash-in-circulation to the total money stock, or M3. They find little evidence of a reduced reliance on cash. For the chart below, I've used M4 which includes not only chequing and savings deposits held at banks but also total postal office deposits:



The cash-to-M4 ratio is a bit lower than it was on the eve of demonetization. For each ₹100 held in accounts, Indians now only hold ₹14.9 in banknotes and coins, down from ₹16 in October 2016. Be careful with using the cash-to-M4 ratio as a measure of preferences for banknotes. If Indians want to hold fewer deposits and more government bonds, M4 declines, and so the cash-to-M4 ratio will rise. But preferences for cash haven't changed at all.

Sunday, November 4, 2018

The credit theory of money

 
Over on the discussion board, Oliver and Antti suggest that I read two essays from Alfred Mitchell-Innes. Here are a few thoughts. 

A British diplomat, Mitchell-Innes was appointed financial advisor to King Chulalongkorn of Siam in the 1890s as well as serving in Cairo. He eventually ended up in the British Embassy in Washington where he penned his two essays on money. The first, What is Money, attracted the attention of John Maynard Keynes, while the second essay, The Credit Theory of Money—which was written in 1914—expounded on his views.

Both are interesting essays and worth your time. One of Mitchell-Innes's main points is that all money is credit. This may have been a controversial stance back in 1914, when people were still very much focused on metallic money, but I don't think anyone would find it terribly controversial today. If we look at the instruments that currently function as money, all of them are forms of credit, that is, they are obligations or "credits on a banker" as Mitchell-Innes puts it.

Having established his credit theory at the outset of his 1914 essay, Mitchell-Innes devotes much ink to patching up its weakest point: coins. Any critic will be quick to point out that the historical circulation of coins contradicts his claim that all money is credit. Coins, especially gold ones, were valued as commodities, not credit.

To protect his credit theory from this criticism, Mitchell-Innes downplays the role played by coins. So in What is Money he claims that for large chunks of history, the "principal instrument of commerce" wasn't the coin, but the medieval tally stick. These ingenious objects look like this:
While I certainly like the idea of tally sticks, to claim that they were the main way of engaging in hand-to-hand trade during medieval times doesn't seem likely. Long and awkwardly shaped, tally stick are not nearly as convenient as coins. It's hard to see why anyone would prefer them. Just like the sleek US$1 bill has driven the bulky $1 coin out of circulation, one would expect coins to push bulky tally sticks out of general usage.
Mitchell-Innes's second, and more radical, line of defence is to claim that coins themselves are a form of credit. "A government coin is a "promise to pay," just like a private bill or note," he says. Elsewhere he writes: "A coin is an instrument of credit or token of indebtedness identical in its nature with a tally or with any other form of money, by whomsoever issued."

This is a strange idea. Why would anyone issue a financial promise encoded on gold? For instance, imagine that I owe you some money. To give physical form to my debt, you ask me to write out an IOU which you will keep in your pocket. But why would I inscribe my promise on something expensive like a gold disc, especially when I could simply record it on a cheap and lightweight piece of paper? Larry White puts it better here:
"This account fails to explain, however, why governments chose bits of gold or silver as the material for these tokens, rather than something cheaper, say bits of iron or copper or paper impressed with sovereign emblems. In the market-evolutionary account, preciousness is advantageous in a medium of exchange by lowering the costs of transporting any given value. In a Cartalist pay-token account, preciousness is disadvantageous — it raises the costs of the fiscal operation — and therefore baffling. Issuing tokens made of something cheaper would accomplish the same end at lower cost to the sovereign."
Mitchell-Innes doesn't make much of an effort to explain why gold might have been selected as a medium for inscribing IOUs. But on the discussion board, Antti has a provocative theory. Credit is often collateralized, an asset being pledged by a borrower to a lender in order to reduce the risk of the loan. If a gold coin is a form of credit, then maybe the gold embodied in the coin is serving as collateral.

Think about it this way. While it would certainly be cheaper for me to record my IOU on paper, if I welch on my promise then the person who holds my IOU is left with nothing but a worthless note. But if I welch on an IOU that is encoded on a gold disc, at least the person who has my IOU is left with some gold (albeit of lower worth than the face value of the original IOU).

According to Antti's theory, a gold coin is therefore a more solid form of credit than a note, since it provides recourse in the form of precious metals collateral. If my credit is bad, the only way I may be able to get a loan is to issue gold IOUs, my paper ones being too risky for people to accept.

It's an interesting theory, but the problem with inscribing my IOUs on gold is that it is a terribly insecure way for me to conduct my business. Gold is highly malleable. Bite a gold coin between your canines and you'll leave a mark on its surface (trust me, I've done it). So if I pay you with my coin IOU, you could clip a tiny bit off the edge and keep it for yourself, passing the rest of the coin off at a store. That store owner could in turn pay it away to a supplier. Unaware that it has been clipped, the supplier returns the coin to me for redemption. I am obligated to accept the clipped coin at full value since it is my IOU. However, I've had a chunk of my collateral stolen somewhere along the transactions chain—and there's nothing I can do about it.

So putting one's gold collateral into circulation is an open invitation for thieves, which is why Antti's collateral theory of coins doesn't seem very realistic to me.

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The idea that coins circulated at more than their precious metals content, or intrinsic value, can be found throughout Mitchell-Innes's two essays. He uses the existence of this premium as proof that the metal content of a coin is not relevant to its value, its credit value being the sole remaining explanation.

To some extent, I agree with Mitchell-Innes. Over the course of history coins have often circulated above their intrinsic value, and from time-to-time this premium has been due to their value as credit. The merchants' counterstamps below are great examples. By adding a stamp to a government coin, these merchants have elevated the coin's value from one cent to five or ten cents.

These three coins are straight out of Mitchell-Innes two essays. As I say in the tweet, counterstamped coins effectively functioned as an IOU of the merchant. For instance, take the five cent Cameron House token, on the right. This token was issued by a Pennsylvania-based hotel—Cameron House.  Its intrinsic value was one cent, but Cameron House's owner promised to take the coin back at five cents, presumably in payment for a room. The sole driver of the coin's value was the reliability of Cameron House's promise, the amount of metal in the token having no bearing whatsoever on its purchasing power.

While Cameron House's stamp turned metal into a much more valuable form of credit, not all stamps do this. Last week I wrote about coin regulators who regulated gold coins and shroffs who chopped coins. Both functioned as assayers, weighing a coin and determining its fineness. If the coin was up to standard, the regulator or shroff stamped their brand onto its face and pushed it back into circulation. Below is a chopmarked U.S. trade dollar:

Chopped 1880 U.S. trade dollar (source)

But unlike the Cameron House stamp, the regulation or chopping of coins didn't turn them into a credit of the regulator or shroff. The marks were simply indicators that the coin had been audited and had passed the test, and nothing more.

Both the Cameron House coin and the chopped U.S. trade dollar would have traded at a premium to the intrinsic value of the metal that each contained. But for different reasons. As I wrote above, the Cameron House coin was a form of credit, like a paper IOU, and thus its value derived from Cameron House's credit quality, not the material in the token. But not so the chopped U.S. trade dollar. Precious metals are always more useful in assayed form than as raw bullion. While it is simple to test the weight of a quantity of precious metals, it is much harder to verify its fineness. This is why chopmarks would have been helpful. Anyone coming into possession of the chopmarked coin could be sure that its fineness had been validated by an expert shroff. And thus it was more trustworthy than silver that had no chopmark. People would have been willing to pay a bit extra, a premium, for this guarantee.

Remember that a decline in the amount of metal in a five-cent Cameron House token would not have changed its purchasing power. With a chopmarked trade dollar, however, any reduction in its metal content flowed through directly to its exchange value. This is because a chopmarked dollar was nothing more than verified raw silver. And just as the value of raw gold or silver is determined by how many grams are being exchanged, the same goes for a chopmarked trade dollar.

And so whereas Mitchell-Innes has a single theory of money, we've arrived at two reasons for why coins might trade at a premium to intrinsic value, and why their purchasing power might change over time. The Cameron House theory, which also happens to be Mitchell-Innes's theory, and the chopmarked trade dollar theory, which is completely contrary to Mitchell-Innes's essays.

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I've used private coinage for my examples, but these principles apply just as well to government coinage. Our modern government-issued coins are very similar to the Cameron House tokens. They are a type of IOU (as I wrote here). In the same way that trimming away 10% from the edge of a $5 note won't reduce that note's purchasing power one bit, clipping some of the metal off of a toonie (a $2 Canadian coin) won't alter its market value. The metal content of a modern coin is (almost always) irrelevant.

But whereas modern government coins operate on Cameron House principals, medieval government coins operated on the same principals as chopmarked traded dollars. In England, a merchant who wanted coins would bring raw gold or silver to a mint to be converted into coin. But the merchant had to pay the mint master a fee. The amount by which a coin's market value exceeded its intrinsic value depended on the size of the mint's fee.

Say it was possible for a merchant to purchase a certain amount of raw gold with gold coins, pay the fee to have the raw gold minted into coins, and end up with more coins than he started with. This would be a risk-free way to make money. Everyone would replicate this transaction—buying raw gold with coins and converting it back into coins—until the gap between the market price of a coin and the market price of an equivalent amount of gold had narrowed to the size of the fee. 

Premia on coins weren't always directly related to mintage fees. English mints usually operated on the principle of free coinage—anyone could bring their gold or silver to the mint to be turned into coin. But sometimes the mint would close to new business. Due to their usefulness and growing scarcity, gold coins would circulate at an ever larger premium to an equivalent amount of raw gold. Since merchants could no longer bring raw gold to the mint and thereby increase the supply of coins, there was no mechanism for reducing this premium.

So as you can see, whether the mint was open and coinage free, or whether it was closed, the premium had nothing to do with the coin's status as a form of credit. It was due to a combination of the superiority of gold in validated form and the availability of validated supply.

In sum, Mitchell-Innes is certainly right that coins have often been a form of credit. A stamp on a piece of metal often elevates it from being a mere commodity to a token of indebtedness. In which case we get Cameron House money. But as often as not, that stamp is little more than an assay mark, a guarantee of fineness. In which case we have chopmarked trade dollars. Both sorts of stamps put a premium on the coin, but for different reasons.

Coming up with grand theories of money is tempting, as Mitchell-Innes has done, but unfortunately these theories sometimes obscure the finer features of monetary instruments. At times, having twenty or thirty bespoke theories may be a better way to understand monetary phenomena than one grand one.