Paper currency helps criminals and constrains central banks—so why do we still use it?by / September 15, 2016 / Leave a comment
Published in October 2016 issue of Prospect Magazine
Has the time come for developed nations to start phasing out most paper currency? A large number of economic, financial, philosophical and even moral issues are buried in this arresting question. But on balance, I believe that the answer is yes.
When I first wrote about the idea 20 years ago, it was pure fantasy. But after the explosion of payment methods, with services like Google Wallet and apps like Venmo joining credit and debit cards, it is no longer unthinkable. Even today, many practical objections can admittedly be raised to the idea of significantly scaling back cash. But my proposal involves leaving small notes in circulation for a long time (perhaps indefinitely), to cover most concerns about everyday payments, security, privacy and emergencies.
I have two main arguments for transitioning to a less-cash (if not quite cashless) society. First, it would make it more difficult to engage in recurrent, large and anonymous payments and thus it would discourage tax evasion and other crime. Second, it is arguably the easiest way to help central banks invoke negative interest rate policies—a tool that would have been of great use during the 2008 financial crisis.
Governments make profits from issuing currency because the cost of minting coins or printing paper notes is less than the market value of the money. But any profits reaped this way are dwarfed by the costs of the illegal activity that cash facilitates.
Tax evasion is a massive problem. It violates what economists call “horizontal equity,” the principle that those with the same income or assets should pay the same amount in taxes. When some people don’t pay the taxes owed on their true incomes, others have to pay more. If some companies use bribes to get around anti-pollution regulations, they gain an unfair competitive advantage and degrade the environment. When businesses go off the books to pay workers less than the minimum wage, they disadvantage competitors that abide by the law.
In addition, tax evasion hampers the efficiency of the tax system. If taxes are evaded more easily by cash-intensive businesses, investment is directed to them rather than to more readily taxable enterprises, which compounds the loss of tax revenue.
In the United States, the Internal Revenue Service (IRS) carries out random intensive audits which, combined with other information, gives it an estimate of the “tax gap,” the difference between the taxes voluntarily paid and the taxes due. In 2006, that gap was $450bn (£341bn). The IRS estimates that 52 per cent of the gap is down to small business owners, who conduct many of their transactions with cash and report less than half of their true income. Perhaps 10–20 per cent of this gap is due to people stashing money in tax havens. But a large amount of tax evasion occurs when there is no third-party information available such as credit card receipts—namely, when cash is involved.
The tax gap is so huge that if eliminating cash could close it by as little as 10 per cent, the revenue would cover the lost profits from paper currency. And that’s not counting the efficiency costs of tax evasion. Nor does it include the damage done by illegal activity, on which taxes are still owed in principle. (Famously, Al Capone was finally imprisoned over income tax evasion.)
Cash plays a starring role in many other crimes, including drug trafficking, racketeering, extortion, political corruption, human trafficking and money laundering. The fact that high-denomination notes are used in illegal activities entered popular culture long ago and is often depicted on television and in films. Yet policy-makers have been slow to acknowledge this reality.
The drug trade is a cash-intensive business. When drug lord Joaquín “El Chapo” Guzmán was arrested at his house in Mexico in 2014, authorities found a trove of cash on the premises. The Rand Corporation estimates that the size of the US market in 2010 for the four biggest illegal drugs—cocaine, heroin, marijuana, and meth-amphetamine—to be more than $100bn. The United Nations Office on Drugs and Crime estimated that in 2003, the global market for drugs was worth £244bn. If the market has expanded in line with the economy, it is now worth £455bn. Eliminating cash would hardly eliminate drug cartels, of course, but it would be a blow to their business model.
Cash also plays a central role in illegal immigration. First, migrants typically pay smugglers in cash, and it costs up to $3,500 for an individual to cross from Mexico to the US, and up to $10,000 to go from Central Asia to western Europe, according to a 2011 Financial Action Task Force Report.
Second and far more importantly, demand from employers ultimately fuels a large part of illegal immigration. Some politicians talk about building border fences, yet a far more effective approach would be to stop workers being paid in cash. It would be much harder and riskier for employers to hire illegal immigrants if compensating them left some sort of record. More generally, the anonymity of paper currency allows employers to skirt employment laws and avoid national insurance contributions.
It is true that anonymous payments can be made in ways other than cash, from prepaid cards to Amazon credits to virtual currencies. These all carry their risks and costs, however.
In the most developed countries, demand for paper currency has been rising for more than two decades, even as the need for it in legitimate transactions has fallen. As of the end of 2015, $1.34 trillion worth of US currency was being held outside banks, or $4,200 floating around for every man, woman and child. The figures are broadly similar in most developed countries. The vast bulk of this stash is in high-denomination notes, the kind most of us don’t carry around, including the US $100 bill, the (soon to be abolished) €500 note, and the 1,000-Swiss franc note. Almost 80 per cent of the US currency supply is in $100 bills. Treasuries and central banks routinely make billions from printing large-denomination notes, yet no one knows where exactly most of it lives or what it is used for. Only a minor fraction is in cash registers or bank vaults, and surveys of consumers in the US and Europe don’t begin to explain the rest.
Even central banks are starting to see this as a mixed blessing. I use the term “reverse money laundering” to describe how central banks effectively take large-denomination notes and ship them to banks where, after a series of intermediate transactions, they often end up in the underground economy.
But central banks should rethink the role of cash not for moral reasons, but because it is a major impediment to the functioning of the international financial system. How can something as antiquated as paper currency be holding back a global economy in which the total value of all financial assets is far greater than the total value of cash? The reason is so banal it is shocking.
“$1.34 trillion-worth of US currency is being held outside banks, or $4,200 for every man, woman and child”
Paper currency can be thought of as a bearer bond, that is an asset unattached to any name or history, which is valid for whoever happens to hold it. Crucially, it is a bond that pays zero interest. That is, no bank is paying interest for the privilege of keeping the money, as it normally would if it was held in an account. But no bank can charge interest on it either. This may seem like the natural state of affairs, but in the last few years central banks in Europe and Japan have experimented with imposing charges for holding money—in other words, negative interest rates. Their customers are banks and other financial institutions, who are likely to see this as the price of doing business and aren’t going to withdraw all their money in cash to keep under a mattress. But people can.
As long as people have the option of paper currency, they aren’t going to accept an interest rate on their bank account that is lower than zero, except perhaps for a small amount compensating for the fact that cash is costly to store and insure. As trivial as the problem seems, this “zero bound” has essentially crippled monetary policy since the crash. Generally, a central bank looking to stimulate the economy cuts the interest rate so that spending becomes more attractive and saving less so. But if interest rates are already at zero, the central bank “runs out of bullets.” If unconstrained negative rate policy were possible—and the necessary financial, institutional and legal preparations made—central banks would always be able to keep cutting interest rates.
Few policymakers worried about this until the financial crisis. Outside post-bubble Japan, the zero-bound constraint has not cropped up since the Depression. But over the past eight years, virtually every major central bank has wished at some point that it could have set significantly negative interest rates. A few who have tried have probed the boundary, where a flight from corporate bank accounts and government debt to other assets or cash would make the policy ineffective or counterproductive.
To work around the zero bound, central banks have tried Quantitative Easing (QE): they have created new money (really very short-term debt) , though electronically rather than by printing. QE’s track record has not been conclusive so far. But my reading is that QE policies did help to alleviate the recession, and arguably, central banks should have done more of it, despite concerns about stability. Nevertheless, even QE enthusiasts say they have little intention of using it once interest rates rise above zero and the normal tools of monetary policy are restored. No one, therefore, is treating it as an all-purpose substitute for conventional interest rate policy.
The idea that negative interest rates might sometimes be good policy, and that paper currency stands in the way, is hardly new. At the height of the Depression, economists from across the spectrum, including Irving Fisher and John Maynard Keynes, reached that conclusion too. The problem back then, as in many countries today, was that interest rates were already at zero. Inspired by the maverick German thinker Silvio Gesell, Fisher wrote a short book Stamp Scrip in 1933, exploring the idea of periodically requiring people to put new stamps on their paper notes to keep them valid—a primitive way of paying a negative interest rate on cash. Keynes praised the idea in The General Theory of Employment, Interest and Money, but came to the conclusion that it was impractical. Rejecting Gesell’s solution helped lead to Keynes’s famous conclusion that government spending was the key to propelling economies out of the Depression.
Yet Keynes might have reached a different conclusion today, when transactions have already increasingly migrated to electronic media. There is nothing impractical about paying negative interest on electronic currency, such as banks hold. The main obstacle to introducing negative interest rates on a larger scale is paper currency, particularly the large-denomination notes that would be at the epicentre of any run from treasury bills into cash. Other institutional obstacles include actually arranging the interest payments, proscribing excessive pre-payment of taxes, and ruling out delays in cashing cheques. However, given enough lead time, all these issues can be dealt with.
“Over the past eight years, virtually every major central bank has wished that it could have set significantly negative interest rates”
The prospect of negative interest rates on cash is an emotionally charged issue. Modern-day Silvio Gesells have met with hostility. In 2000, Richmond Federal Reserve official Marvin Goodfriend published a paper suggesting that one way would be to embed magnetic strips on currency, which could be used to track how long it had been out of circulation and charge people accordingly. Goodfriend received a barrage of threatening emails, and was pilloried on conservative radio talk shows. In 2009, Harvard economist N Gregory Mankiw wrote a New York Times article that mentioned an idea of one of his graduate students: that of holding periodic lotteries based on the serial numbers on currency. After each lottery, currency with the losing numbers would be declared worthless. This unorthodox way to pay a negative rate on cash was put forth only for illustrative purposes. Yet Mankiw was subjected to vicious criticism, including letters to the President of Harvard demanding that he be fired.
Of course, most fans of paper currency have perfectly legitimate reasons. After a lecture I gave at Munich University, Otmar Issing, former Chief Economist of the European Central Bank took exception and said that cash is “coined liberty” (a nod to Fyodor Dostoyevsky’s House of the Dead) that must never be compromised or surrendered. Paper currency has qualities which at present no other medium can duplicate: near total privacy, near instantaneous clearing of transactions, robustness to power outages and—of course—deep penetration into social consciousness and culture.
Some people prefer the convenience of cash, though its advantages persist in an ever-smaller range of legal transactions. Others value the anonymity, a more complex issue. How does society balance an individual’s right to privacy with society’s need to enforce its laws? Deciding where that line should be is perhaps the most critical question. The issue of privacy is a wider one, encompassing mobile phone records, internet browsing histories and CCTV. Cash, though, is an important part of the mix.
How would phasing out most cash (or to be precise phasing out bills larger than $10) work in practice? The speed of transition needs to be slow, stretching over at least 10 to 15 years, so that institutions and individuals have time to adapt. The simplest way to start would be for governments to stop printing large-denomination notes. Over time, these notes would need to be tendered for their value at private banks or government offices, prior to that denomination being withdrawn from circulation. The way by which the eurozone countries exchanged national currencies for euros provides elements of a blueprint.
The process would then shift to medium-value banknotes. Low-value notes could be left in circulation indefinitely, or until suitable alternatives are found. They could also be replaced by coins of substantial weight, which would have to be burdensome to carry around and conceal in large amounts.
Alongside these changes, the government needs to ensure universal financial inclusion, by providing all individuals with access to free basic-function debit card or smartphone accounts (and smartphones, if necessary). This can be substantially implemented by making all government transfer payments into the debit account. At present, many poor people do not have bank accounts—in 2013, more than 8 per cent of households in the US did not—and face high fees for cashing cheques or wiring money, so this policy would have the effect of reducing poverty too.
There also needs to be a regulatory and legal framework to discourage other means of making large-scale payments that can be hidden. Private mechanisms for small-scale quasi-anonymous transactions already exist, for example, prepaid cards; the issue is already on the radar of governments.
Finally, the government has to facilitate development of payment infrastructure to achieve near real-time clearing for most transactions. At present, electronic payment mechanisms cannot duplicate the real-time clearing of cash. Ordinary credit cards and debit cards take a day to clear. But new technologies are peeling away these limitations of digital payments. Apps like Venmo and Square Cash offer reasonably fast clearing and the options are likely to proliferate and improve. Denmark is among several countries that have developed widely used systems.
Power outages are one of the more compelling reasons for keeping small notes and change in circulation. Nevertheless, the average person does not carry large cash balances and cashpoints may not work during a power outage. Arguably, the most important disaster preparedness tool is now a smartphone and will only become more so as payment systems migrate to phones.
In principle, no new instruments are required to shift to a less-cash world; in particular, digital currencies are not required. (My argument is essentially orthogonal to digital currencies like Bitcoin; they are competitors for other financial instruments and institutions, not so much for cash.) Transactions will continue shifting to cards and smartphone apps in any case.
As for the international dimensions of the problem, a co-ordinated phaseout of currencies among developed countries would be the most effective policy. The domestic benefits alone, however, justify phasing out most paper currency, even for the US and Europe. Smaller developed economies and Japan, whose currencies are not used internationally, face even fewer barriers.
Phasing out big bills would not be a free lunch, they are very popular and account for vast bulk of the currency supply In recent years, the US has averaged profits of 0.4 per cent of GDP from issuing paper currency, and the eurozone has averaged 0.55 per cent. If the US government had to issue bonds to buy back its entire supply of paper currency, it could add more than 7 per cent of GDP to the national debt; the eurozone could add 10.1 per cent.
The topic of phasing out paper currency has so far been debated only in obscure corners of monetary economics. But it is hugely consequential. Most economists and policymakers seem content to let paper currency ride quietly into the sunset over the next 100 years or so, thinking the system works pretty well and that the issue doesn’t matter much. They couldn’t be more wrong. The enormous quantity of cash circulating is a massive public policy problem that needs to be urgently discussed, not taken as an immutable fact of life.
This article has been amended to emphasise that the author calls for leaving small bills in circulation indefinitely, and does not propose to eliminate cash altogether.