When the feds finally come for your cash
The future of money may be playing out in India. The Indian economy is largely cash- based, making it easier to evade taxes and for criminals to operate. Crime and tax evasion are hardly unique to India, but the Indian government has taken the drastic step of taking their highest denomination notes — 500 rupees and 1,000 rupees — out of circulation. ( At current exchange rates, 1,000 rupees is equivalent to 20 Canadian dollars). These notes account for about 86 per cent of the value of currency in circulation, and Indians have until the end of the year to exchange their old notes with new 500 and 2,000 notes.
“Demonetization” — as it’s come to be called — is proving to be far more costly than expected. Although the Indian government’s main targets are holders of large, ill- gotten gains, many poor and rural households without access to the banking system risk losing most of whatever wealth they have managed to set aside. Worse, the transition to the new notes is not going as smoothly as planned, leading to cash shortages and a decline in spending. The contractionary effects of such a large reduction in the money supply are likely to produce a recession in India.
Even so, the idea of drastically cutting back on the amount of currency in circulation, and on high- denomination bills in particular, is gaining traction in other countries. More than $1 trillion of U. S. currency in circulation — almost 80 per cent of the total — is in the form of $US100 notes. That works out to more than US$3,000 per American, and if you think that’s an implausibly large number, you’re quite right: several esti- mates suggest that roughly half of those $ US100 notes are circulating outside the U. S. Many — if not most — of those U. S. banknotes are used to settle payments for illegal drugs, weapons and other contraband. Similar concerns have been raised for the volume of €500 notes circulating outside the euro zone. To a very great extent, the main contribution of maintaining high-denomination USD and euro notes is to ensure the smooth functioning of the underground world economy.
High- denomination Canadian banknotes are of course less important on the international scene, but $ C100 notes still account for more than half of the $ C75 billion in Canadian banknotes in circulation. Given that so many merchants have long since stopped accepting $ C100 notes — or even $ C50 notes — it’s not clear what would be lost if they suddenly disappeared from the Canadian economy.
Although crime and tax evasion are important considerations, the conduct of monetary policy in a low- inflation environment is an even more important reason why high- profile economists such as Harvard’s Kenneth Rogoff are advocating the abolition of highdenomination currency. When inflation is low and the economy is operating below capacity, the standard response of central banks is to reduce interest rates to promote investment and expenditures on interest- sensitive goods such as housing and automobiles. But what matters here is the real interest rate — the nominal interest rate charged by financial institutions less the inflation rate. A strongly stimulative policy stance often brings about negative real interest rates, where the interest rate is less than inflation. In such a world, you can earn a profit by borrowing and repaying the loan with money that is worth less than the original debt.
There’s a limit to this strategy, though: interest rates in industrialized economies are close to zero. When interest rates reach zero, the supply of loans dries up: people will rather hold their assets as currency and earn zero interest rather than lose money by leaving it in the banking system.
Or at least, that’s what we used to think. It turns out that large institutions are willing to tolerate losing money if the alternative is arranging their own security for large cash holdings: trillions of dollars are currently “parked” in negative- return assets. But this just means that the lower bound for interest rates is a bit less than zero, not that there isn’t one: at some point, those investors will prefer to switch into cash rather than continue to lose money.
If eliminating high- denomination bills makes it harder to maintain large holdings of cash outside the banking system, then it becomes easier for monetary authorities to maintain negative interest rates. If savers are obliged to pay interest on their deposits, then they’ll be less reluctant to lend at money-losing rates.
There are counter-arguments, of course, not least the ones posed by the experience in India. But in advanced countries such as Canada and the United States, the administrative challenges of replacing high-denomination notes for (say) $ 20 bills are surmountable. ( The possibility of shady characters abroad suddenly finding themselves with suitcases full of worthless paper is of course a feature, not of bug of the proposal.) In addition, central banks would lose some “seigniorage” revenue: the licence to print money generates almost $ 2 billion for the Bank of Canada.
More fundamental are privacy conditions: cash payments remain one of the few ways to make anonymous transactions in the modern economy. A related consideration is the rise of crypto-currencies such as bitcoin. Will people simply switch from central bank’s fiat currency to private money? And if they do, will it matter?
Virtually all existing scenarios for the future imagine a world without cash, and they’re probably right. The tricky bit will be managing the transition: it always is.
WILL PEOPLE SIMPLY SWITCH FROM (FIAT CURRENCY) TO PRIVATE MONEY?