Economists usually talk about money serving three functions – a medium of exchange, a store of value, and a unit of account. But the ability to make payments using commercial bank deposits, which account for the vast majority of money, has already divorced the physicality of notes from the concept of the medium of exchange. Inflation and non-remuneration renders physical money a poor store of value. And the unit of account does not rely on physical cash. So is there a specific role for physical paper money anymore?
How to make the Mob miserable – revisited
The idea of demonetisation – the replacement of some or all of the physical stock of notes – is not new. James Henry’s 1980 article “How to make the Mob miserable” focused on High Denomination Notes (HDNs). HDNs have historically been convenient for paying for expensive items, and offer the buyer anonymity and the ability to transport large amounts of wealth easily. But these latter qualities are double-edged swords. Henry’s article argued that a large share of HDNs was likely held by “tax evaders, drug traffickers, illegal gamblers, loan sharks, fencers of stolen goods and corrupt politicians.” His policy prescription involved a surprise currency recall within a short window of time, with the tax authorities lying in wait when “the tax cheats, Mafiosi and other pillars of the criminal community rushed to their banks to exchange their precious notes”.
Henry’s policy was, self-admittedly, impractical in 1980. But his proposal perfectly echoes India’s surprise demonetization in November 2016. And as discussed by Peter Sands, HDNs are increasingly “an anachronism in a modern economy” given the advent of contactless payments and digital wallets which increased the speed and convenience of settling payments using bank deposits. Similar arguments are made in Kenneth Rogoff’s book, The Curse of Cash.
A number of central banks, including the ECB, the Bank of Canada and the Monetary Authority of Singapore, have already started, or have announced plans, to phase out their HDNs. In the United States, which had already phased out a range of HDNs in 1969, both Kenneth Rogoff and Larry Summers have argued for a gradual demonetisation, starting with a moratorium on printing new $100 bills.
Demonetisation and the criminal economy
The main argument for eliminating HDNs is to reduce criminality. As Sands explains, $1million dollars would take up 3.5 briefcases if held in new $20 bills, but only one small bag if held in 500 EUR notes (Chart 1). Used notes could take twice as much space.
Chart 1 – Number of 15 litre briefcases required to hold $1 million of new notes
Source: Sands et al (2016)
Similarly, a 2015 Europol Report argued that cash is an “entirely legal facilitator, which enables criminals to inject illegal proceeds into the legal economy with far fewer risks of detection than other systems”. Indeed, both Europol and Sands find that criminals tend to pay a convenience premium for HDNs because they are easier to transport. Sands’ work generally estimates the premium at 5%-10%.
As well as improving social outcomes through reducing crime, the demonetisation policy is also expected to significantly increase tax receipts, as money is forced from the criminal economy into the taxable economy. Rogoff estimates a US “tax gap” – the difference between what is, and what should be collected in tax revenues – to be around $500bn in 2015. He thinks at least half of that derives from cash-intensive areas – and so even if only a fraction can be recouped it could lead to a significant rise in tax receipts. In the UK, HMRC estimate that the “tax gap” was £36 billion in 2015.
These potential financial gains sound significant. But I would expect the macroeconomic impact may be limited because the transfer of funds to the government is offset by a reduction in household and business wealth. Indeed, the distributional consequences may serve to reduce economic growth. For example, if cash-in-hand payments – a potential enabler of VAT and income tax evasion – are disproportionately made to poorer workers with higher marginal propensities to consume, and the government’s redistribution policies are not sufficiently progressive, then the demonetisation could reduce overall spending.
Another argument is that demonetisation could lead to a fiscal boost because some notes may not be returned. This, it is argued, would create a windfall for the government by absolving them of a liability without any corresponding reduction in assets. But as discussed in various blogs (e.g. by Peter Stella) the boost from this ‘reverse helicopter drop’ only occurs if the central bank (rather than just commercial banks) refuses to exchange the old notes for new ones. I am not a lawyer, but I would argue that ‘de-recognition’ of a perpetual sovereign liability (notes) would amount to a government default.
Monetary policy and the seigniorage red herring
The elimination of HDNs would, however, generate monetary policy benefits. Currently the ability to switch deposits into banknotes (with a fixed 0% nominal return) limits central banks’ ability to set negative nominal interest rates. Eliminating HDNs would help alleviate this constraint by increasing the costs of such a switching strategy (e.g. wholesale note hoarders switching from holding £50s to £20s would require a 2.5x increase in vault space to store the same amount). Although there is still significant resistance to negative nominal interest rates, such policies may become increasingly important in a world of low neutral interest rates (see Rachel and Smith) and inflation targets. That is because it is reductions in real interest rates that drive economic recovery – something that was particularly important in the recovery from the US Great Depression (see Crafts).
In terms of costs, one of the arguments against demonetisation is the loss of ‘seigniorage income’ – the economic rents governments earn from their monopoly over cash issuance. The argument is that a large-scale return of physical notes leads to a re-composition of the central bank’s existing liabilities away from non-interest bearing notes in favour of interest-bearing central bank reserves or long-term debt.
I, however, believe that the focus on seigniorage income is misplaced, because many central banks are free to set their reserves remuneration policies. As a result, the central bank could offset lost seigniorage by requiring banks to hold unremunerated funds at the central bank, either through reserve requirements or, as in the UK, through ‘cash ratio deposits’. If the unremunerated share of reserves remains relatively small, this need not interfere with the implementation of monetary policy, which relies only on the marginal remuneration rate. And this additional tax on the banking sector could be offset (at least in part) by lower costs of note storage, sorting and distribution.
Design is important, execution is critical
India’s experience does, however, demonstrate that execution is critical to a successful demonetisation (discussed here and here). I would argue that some of the problems India encountered – including the incompatibility of the new notes with the ATMs, and the immediate illiquidity of new HDNs due to a shortage of small change – are easily avoidable. But the challenges of demonetisation in cash-intensive, under-banked economies, with significant rural/urban inequality, and where notes are used as a store of wealth are harder to overcome. This is one reason why many, including Rogoff, do not recommend demonetisation in developing economies. I would agree.
Are there any lessons for the UK?
In the UK, HMT is responsible for approving the UK note denominations. The Bank of England then looks to provide good-quality and counterfeit-resilient banknotes in the mix of denominations demanded by the public – making sure that we have “the right note, in the right place, at the right time”. In recent years, this mantra has led to increases in the number of £5s in circulation, as well as the move to polymer notes.
As far as HDNs go, the UK starts from a good place. The highest-value note, the £50, is small when compared to some of the HDNs being phased out elsewhere. And the value of outstanding banknotes is relatively low, as a share of GDP, compared to a range of other countries (Chart 2).
Chart 2 – Value of notes outstanding as a proportion of GDP
However, the £70bn stock of notes is still equivalent to over £1,000 per head. Even adjusting this estimate down for cash held overseas and amongst wholesale FX dealers suggests UK per capita cash holdings are large (evidence gathered by the Bank suggest less than 50% of the notes are held domestically). Moreover, the note issue continues to grow by around 5% a year, despite falling usage of notes for transaction purposes. Understanding this “paradox of notes” remains an important policy issue.
Personally, I think that the growth of faster and more efficient payment technologies will reduce the future transaction demand for money, and that a gradual demonetisation of HDNs should follow. In the UK, the process could start with natural run down of the stock of £50s, as old and damaged notes are withdrawn from circulation.
Ronnie Driver is on an external secondment from the Bank’s Sterling Markets Division.
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