Wednesday, March 21, 2018


I am a big fan of coinsplainers like Andreas Antonopoulos. Listening to Andreas explain how bitcoin works is a great learning opportunity for folks like myself who know far less about the topic. I am less impressed when bitcoiners engage in fiatsplainin', since they generally have an iffy understanding of the actual financial system and central banking in particular.

So for the benefit of not only bitcoiners, but anyone interested in the topic of money, I'm going to fiatsplain' a bit. (I really like this term, I got it from an Elaine Ou blog post)

Paul Krugman recently had this to say about the difference between bitcoin and fiat money:
"So are Bitcoins a superior alternative to $100 bills, allowing you to make secret transactions without lugging around suitcases full of cash? Not really, because they lack one crucial feature: a tether to reality.
Although the modern dollar is a “fiat” currency, not backed by any other asset, like gold, its value is ultimately backed by the fact that the U.S. government will accept it, in fact demands it, in payment for taxes. Its purchasing power is also stabilized by the Federal Reserve, which will reduce the outstanding supply of dollars if inflation runs too high, increase that supply to prevent deflation.
Bitcoin, by contrast, has no intrinsic value at all. Combine that lack of a tether to reality with the very limited extent to which Bitcoin is used for anything, and you have an asset whose price is almost purely speculative, and hence incredibly volatile."
Now if you've been reading my blog for a while, you'll know that I agree with Krugman's point that bitcoin lacks a tether to reality while a banknote doesn't. He mentions two forces that anchor a $100 banknote, or provide it with intrinsic value: tax acceptability and a central bank's guarantee to regulate its quantity. Let's explore each of these anchors separately, starting with tax acceptability.


The idea that taxes can determine the value of a fiat currency is easier to grasp by looking at currencies issued during the American colonial era. Coins tended to be scarce in the 1700s and there were few private banks, so the legislatures of the colonies issued paper money to meet the public's demand for a circulating medium. They had a neat trick for ensuring that this paper money wasn't deemed worthless by citizens. A fixed quantity of paper money was issued concurrently with tax legislation that scheduled a series of future levies large enough to withdraw each of the notes that the legislature had issued. This combination of a fixed quantity of notes and future taxes of the same size was sufficient to give paper money value, since the public would need every bit of paper to satisfy their tax obligations.

Examples of colonial currency (it's worth enlarging this image to see the detail) From: Early Paper Money of America

Crucially, once a colonial government had received a note in payment of taxes, it removed said note from circulation and destroyed it. If the government re-spent notes that had already been used to discharge taxes, this would be problematic. The tax obligation would be more-than-used-up, leaving no reason for the public to demand outstanding banknotes. Krugman's "tether to reality" would have been removed.


The modern day version of Krugman's tax acceptability argument is a bit more complicated. For starters, no one actually pays their taxes with banknotes. Rather, the tax acceptability argument applies to a second instrument issued by central banks otherwise known as reserves (in the U.S.) or settlement balances (in Canada). All commercial banks keep accounts at the central bank, these accounts allowing them to make instant electronic payments to other banks during the course of the business day, or to the government, which typically will also have an account at the central bank.

When Joe or Jane Public are ready to settle their taxes, they initiate a set of financial transactions that ultimately results in their bank depositing funds on their behalf into the government's account at the central bank. To satisfy the public's demand to make tax payment, commercial banks will want to have some central bank settlement balances on hand. So the existence of taxes "drives" banks to hold a certain quantity of central bank settlement balances, thus generating a positive price for these instruments. And since a banknote is in turn tethered to a central bank deposit via the central bank's promise to convert between the two at par, by transitivity the banknote is also tethered.

Unlike the colonial era, however, the tax authority—the government—can't destroy money. The government can either accumulate central bank deposits, or spend them, but it can't cancel them. What generally happens with the government's account at the central bank is that as soon as it is topped up with some tax receipts, they get quickly spent on government programs, salaries, and other expenses. So these funds simply boomerang right back into the accounts that commercial banks keep at the central bank, undoing the tethering that is achieved by tax acceptability.

Put differently, for every bank that demands settlement balances to pay taxes, and thus help gives those balances value, there is a government official who spends them away, and negates this value. So government taxes by themselves don't anchor modern central bank money.

To really anchor the value of central bank money, the government needs to withhold from spending the money it has received from taxes. The more it resists spending incoming tax flows, the more balances accumulate in its account at the central bank. If the government keeps doing this, at some point almost every single deposit that the central bank has ever issued will have been sucked up into the government's account. With almost no deposits remaining for paying taxes—and thus no way for the public to avoid arrest for failure to meet their tax obligations—the value that banks collectively place on deposits will reach incredible heights.

And that explains how tax acceptability (combined with a strategy of not spending taxes received) can provide modern fiat money with backing sufficient to generate a positive price.


Let's turn now to Krugman's second reason for central bank money having intrinsic value, the central bank itself. As I said earlier, a government can freeze deposits by accumulating them, but it can't destroy them. The only entity that can destroy money is the central bank. It achieves this is by conducting open market sales of bonds and other assets. When it sells a bond to a bank, the central bank gets one of its own deposits in return, which it proceeds to destroy.

Imagine that banks collectively decide they have too many central bank deposits and start to sell them (a scenario I discussed here). This sudden urge to rid themselves of money will cause inflation. In a worst case scenario, they will get so desperate that the purchasing power of money falls to zero. The central bank can counter this by selling assets and destroying deposits. In the extreme, it can sell each and every one of the assets it owns, shrinking the deposit base to zero. Its actions will drive the value of deposits into the stratosphere, since banks need a token amount to make interbank payments.

And that, in short, explains how central banks can provide dollars with backing sufficient to generate a positive price.


Which of Krugman's two forces—tax acceptability or a central bank's guarantee to regulate the quantity of money—is more important for imbuing little electronic bits with value?

We know that a government can anchor a fiat money purely through tax acceptability. Colonial money proves it. (Here is another example from the Greenback era) But can a fiat currency be anchored solely through the actions of the central bank, without the help of tax acceptability? Let's set the scene. Imagine that the government has unplugged itself from the central bank by closing its account and instead opening accounts at each of the nation's commercial banks. Since all incoming tax receipts and outgoing government payments are now made using private bank deposits, the government no longer generates a demand for central bank settlement balances.

This "unplugging" needn't drive the value of central bank money to zero. The central bank has assets in its vault, after all, so any decline in the value of central bank money can be easily offset by an appropriate set of central bank open market sales and concomitant reductions in the quantity of deposits. So the answer to my question in the previous paragraph is that money doesn't require tax acceptability to have intrinsic value. Tax acceptability is sufficient, but not necessary.

That being said, on a day-to-day basis the value of modern central bank money is regulated by a messy combination of both factors. Money is constantly flowing in and out of the government's account at the central bank, and this can have an effect on the purchasing power of money. Likewise, central bank open market operations are frequently conducted on a daily basis in order to ensure the system has neither a deficiency nor an excess of balances. It's complicated.

And that ends this episode of fiatsplainin.' Fiat money is indeed backed and has intrinsic value, as Krugman says, and it does so for several reasons.

PS. If you are interested in colonial currency, you should read some of Farley Grubb's papers.


On Twitter, someone had this to say about my post:
฿ryce gives me the perfect opportunity to keep fiatsplainin'. Contrary to ฿ryce's claim, the fact that Arizona plans to accept tax payments in the form of bitcoin does not provide bitcoin with a tether to reality. For every bitcoin that Arizona accepts, it will just as quickly spend it away. The first is undone by the other. You'll notice that this is the same reason I gave for modern central bank money not necessarily being anchored by tax acceptability; whereas taxes vacuum up central bank money, government officials typically reverse this vacuum by quickly spending it, so the net effect is a wash.

To tether central bank money to reality, governments need to not only make it tax acceptable but also  be ready to let those balances pool up in its account, thus setting a limit on the overall supply of balances. Likewise with bitcoin. If the Arizona government were to accumulate incoming bitcoins as part of an overall policy of never spending them, then it would be removing bitcoins from circulation, in essence "destroying" them. And this would provide bitcoin with a true anchor. Of course the Arizona government isn't going to do this. It will want to rid themselves of bitcoins the moment it gets them.

Wednesday, March 7, 2018

Indians' "ill-informed notions" concerning the legitimacy of ₹10 coins

The BBC has an interesting story about India's coinage. Apparently more and more Indians  believe that the ₹10 coin is not real, or that it has been banned by the authorities, and as a result they are unwilling to accept them in trade. Doubts about the ₹10 coin have been emerging for several years now: Amol Agarwal has covered the story here, here, and here.

This is an excerpt from the BBC article:
"Nobody accepts the coins - grocery shops, tea stalls, nobody accepts it", an auto rickshaw driver in the southern state of Tamil Nadu told BBC Tamil.
In the southern city of Hyderabad, a young girl told BBC Telugu she had been saving up to buy her brother a gift but several shop owners wouldn't take her 10 rupee coins.
A man on his way to a job interview was forced to get off the bus because the conductor wouldn't accept 10 rupee coins, the only currency he had.
"They say it's because the other passengers don't accept the coins in return", explains a shop owner who also said bus conductors wouldn't take the coins.
The Reserve Bank of India (RBI) has twice addressed the public's worries about the ₹10 coin. In a 2016 announcement it begged Indians to ignore "ill-informed notions" concerning the legitimacy of ₹10 coins and to continue to "accept these coins as legal tender in all their transactions without any hesitation." More recently, in a January notice, we learn that the RBI has issued fourteen different designs for the ₹10, all of which are "legal tender and can be accepted for transactions."

What are the underlying reasons for Indians' fears? One interesting fact about the ₹10 coin is that it is relatively new, having been introduced back in 2009. People are always skeptical about new monetary instruments, which generally take a long time to acquire trust.

Another interesting fact is that in addition to minting a ₹10 coin, the RBI also prints a ₹10 banknote. The ₹10 banknote has a long history, having debuted before independence in 1947. Below is a chart showing how many of each instrument is in circulation. The year-over-year net increase in banknotes continues to outpace the increase in coins by a large amount, indicating that  Indian's have a preference for the paper version of the ₹10.

I think there is an easy explanation for the ₹10 coin's loss of currency. Because the ₹10 coin and ₹10 note are perfect substitutes, and converting between them incurs no conversion costs, there is no disciplining mechanism to prevent irrational worries about the newer of these two instruments from crippling its usage. Put differently, hating new ₹10 coins doesn't impose any costs on the hater as long as an equivalent banknote can be used. If there was no such thing as the ₹10 banknote, then anyone who refused to use the ₹10 coin would face much higher costs for being unreasonable. After all, holding two ₹5 coins or five ₹2 coins in the place of a ₹10 coin is inconvenient.

The denomination at which a monetary system switches from coins to notes is referred to by Rocheteau and Lotz (pdf) as the coin-note frontier. In Canada, for instance, the frontier lies between the $2 coin and $5 note, while in Switzerland it lies between the 5 franc coin and 10 franc note. Most frontiers (like Canada's and Switzerland's) are staggered—the largest coin is smaller than the smallest note. This staggering makes a lot of sense. Why should both the nation's mint and its printing presses incur the fixed costs of producing the same unit when one will suffice? Consider too the waste incurred in the doubling-up of the tasks of distributing, sorting and handling a coin and note of the same denomination.

Unlike most countries, India has an even coin-note frontier. For some reason, the Indian monetary authorities have decided to have both the mints and the presses replicate the same task of producing the ₹10. Interestingly, India isn't alone. The U.S.'s largest coin is $1 while the smallest note is $1.

The US's $1 coin, introduced in 1979 and referred to as the Susan B. Anthony dollar, is commonly considered to be a major monetary failure. I wrote about it here. $1 coins have proven to be unpopular with the American public, huge amounts of them accumulating in vaults at various Federal Reserve banks. Because the US monetary authorities decided to introduce the $1 coin without removing the $1 bill, the public was given a choice between a perceived "good" currency, the existing and comfortable note, and a "bad" currency, an unfamiliar coin. They took the less costly route and stuck with the "good" notes. My guess is that the very same forces that doomed the $1 coin could end up killing off the ₹10 coin.

The failure of the $1 and ₹10 coins is unfortunate. As Rocheteau and Lotz point out, replacing low denomination notes with coins is a good idea because the the cost of keeping bills in circulation is greater than the cost of servicing coins. While coins are more expensive to produce, they last much longer than bills.

So not only are the US and India doubling up their costs by having both the mint and printing presses produce the same instrument, but at the same time the decision to keep the note in circulation means that the more efficient instrument—the coin—is destined to fail. The Reserve Bank of India blames the public's "ill-informed notions" for the ₹10 coin's loss of currency. But perhaps it should be blaming itself for providing the right conditions that allow for the spread of these ill-informed notions. Remove the ₹10 note and the problem will be fixed.

Amol Agarwal has some comments here.

Friday, March 2, 2018

The odd relationship between gangster and central banker

In my recent post for the Sound Money Project, I touched on the odd relationship between central banker and gangster. I want to focus a bit more on this relationship.

An awkward truth of central banking is that one of the central bank's most important lines of business—the business of providing cash, specifically high denomination banknotes—primarily serves hoodlums, gangsters, tax evaders, and the mafia. Yes, non-criminals certainly make some use of high denomination banknotes, say a few notes hidden in the cookie jar in case the electricity goes down. But the largest base of users is comprised of folks who hold notes—not in cookie jars—but by the suitcase full; criminals. Banknotes are anonymous after all, so they are an excellent way for criminal organizations to make large-scale transactions without being traced.

Providing criminals with high-denomination banknotes is a lucrative line of business. For each $100 note put into circulation, a central bank holds $100 worth of interest earning assets in its vaults. Since note holders don't have the right to receive any interest, the central banks gets to keep all this interest income for itself.

For instance, by the end of 2016 the Bank of Canada had placed $80.5 billion worth of banknotes into circulation. Large denomination banknotes—the $50, $100 and $1000 notes—accounted for $58.4 billion of this, or around 72% of all banknotes. The assets standing behind all outstanding banknotes allowed the Bank of Canada to earn $1.53 billion in interest in 2016. Of this amount, around $1.1 billion (72% of $1.53 billion) can be attributed to high denomination banknotes, the majority of which comes courtesy of the largest holders of high denomination notes: gangsters.

So you can begin to see why the Bank of Canada might not want to get out of the business of producing $50, $100, and $1000 notes. $1.1 billion is a lot of profit! Of course, were the Bank to get out of producing high denomination notes altogether, it wouldn't forgo the entire $1.1 billion in yearly income. Criminals might choose to use $10 and $20 notes in the place of the demonetized high denomination notes. However, $10s and $20s are a bulky way to store value. They surely wouldn't be capable of recapturing all of the criminal wealth formerly held in the form of $50, $100, and $1000 notes. Which means that the total amount of banknotes outstanding would fall and Bank of Canada profits would shrink.

Why might central bankers care about their profits? As I wrote here, any government bureaucrat who can provide their master with an ongoing revenue stream will always have more say in their department's fate than a bureaucrat who has to ask for funding each year. And of all government bureaucrats, none is more jealous of their independence than the central banker. The process of ratcheting the interest rate lever higher or lower requires a complete absence of political meddling, so say central bankers. One might imagine that this autonomy is worth so much to central bankers that it justifies taking on a clientele dominated by gangsters.

There is a better reason for why it might be in the public interest for central bankers to continue serving criminals with high denomination banknotes. Consider the fact that if high denomination notes were to be rescinded, criminals would simply use other forms of payment in their place. If the substitute payments medium that criminals select places a new and extremely onerous set of burdens on society, then maybe the public provision of high denomination notes should not be discontinued.

What alternative payments media might criminals use in the place of $100 and $50 notes? In his screed against high denomination banknotes, Ken Rogoff suggests that gold, uncut diamonds, and bitcoin might become popular as a criminal payments media. The fact that these instruments are cumbersome relative to cash would make criminals easier to catch, and Rogoff claims that the crime rate might even drop.

In a provocative article, James McAndrews counters that rather than turning to commodities, criminals will instead select private debts as their preferred payments medium. A thief who sells stolen goods to a fence would accept some sort of IOU as payment rather than cash or diamonds. This IOU wouldn't be anonymous. Like any debt, the debtor and creditor would be a matter of record. But as long as the system of debts is secret—i.e. only criminal participants can see the record—then the users can't be tracked by the authorities, like cash.

When an IOU defaults, the traditional legal system provides a means for sorting things out. But this system would be out of bounds to criminals trafficking in IOUs. What is required is some sort of underground administrator or third-party to act as arbiter. According to McAndrews, the party that is likely to emerge as enforcer of criminal debts is organized crime: the mafia. 

In addition to enforcing IOUs, the mafia would also be in a position to fabricate new IOUs for use in the criminal monetary system. McAndrews uses the example of inflated invoices. The mafia would coerce legitimate businesses into writing IOUs, or invoices, for goods they never bought, or bought  at inflated prices. These invoices would circulate among criminals as money. To assure that the police ignored their extortion of legitimate business, the mafia would resort to stepped up bribery of the police.

All of this changes the calculus of a central bank withdrawal from the business of providing criminals with banknotes. Sure, a demonetization of high denomination notes might lead some gangsters to go legit because the lack of $100 and $50 notes makes their business too expensive to operate. But a whole new range of crimes could emerge. Violence could grow as the mafia executes defaulters in order to maintain the sanctity of the new IOU payments system that has taken the place of high denomination banknotes. Legitimate businesses could get blackmailed into feeding the criminal monetary system, those run by immigrants likely being the most vulnerable. And police departments will be corrupted.

McAndrews uses the public provision of free condoms and clean needles as an analogy. Restrict free condoms and it is possible that the rate of sexual intercourse goes down. But surely there will be an increase in unsafe sex, unplanned pregnancy, and sexually transmitted diseases. As for the provision of clean needles, restrict it and heroin use might fall. However, the prevalence of HIV will rise. Both unsafe sex and dirty needle usage impose costs not only on those directly afflicted but also indirectly on us—i.e. taxpayers who pay increased health care expenditures.

Likewise with cash. A restriction of $50 and $100 notes could very well lead to attrition in the ranks of existing criminals, as Ken Rogoff reasons. However, this could be twinned with an increase in mafia activity and the potential subordination of us—i.e. legitimate business—to the needs of the underground payments system. Keeping high value banknotes may thus be the wise decision, in the same way that choosing to keep free condom and clean needle programs going makes everyone's lives better off.

Tuesday, February 20, 2018

Cash, cat, and mouse

Bruno Liljefors, 1899, link

The tax authority and the tax payer are engaged in an age-old cat and mouse game, tax payers trying to perfect tricks that allow them to pay as little tax as possible and the tax authority trying to close these loopholes. Retail cash payments are one of the fields on which this battle is waged. It's interesting to see how sophisticated this cat and mouse game has become.

There are two weak points in the sales process that allow cash-accepting retailers to avoid paying sales taxes or VAT. The first weak point is at the very outset of a payment. When a customer pays with cash, the person behind the till can avoid ringing up the payment. Without a record of the payment having been made, the retailer needn't pay tax.

But even if a retailer rings up all cash payments and provides receipts, they can still avoid paying taxes. At the end of the business day, they need only doctor the cash register's data using a zapper—add on hardware or software designed for this purpose—in effect purging all or a portion of the cash payments registered during the course of business. With the only record of that day's cash payments now being the paper receipts held in customers' wallets—most of which will have been thrown away—the retailer needn't worry about the tax authority discovering the doctoring. (Erasing card based payments is much riskier for the retailer because a paper trail still exists with the card-issuer.)

Tax authorities have been targeting the second point of weakness for a few decades now by requiring retailers to use certified cash registers that have tamper-proof memory units. These are variously known as a fiscal control units, electronic tax registers, or fiscal tills. These tills are designed in such a way that any attempt on the part of the retailer to break into its memory using a zapper or some other technique will be discovered. Additionally, these units have the potential to be connected directly to the tax authority, allowing for instantaneous transmission of sales data and constant real-time tax auditing. That sounds a bit intrusive, no?

Below is a chart from the IMF showing nations that have implemented fiscal till plans:

Source: IMF, Electronic Fiscal Devices, 2015

Progressing to the next stage of the cat and mouse game, retailers will try to evade tamper proof memory units in the cash register by making recourse to the first weak point in the sales process; not entering the transaction into the cash register in the first place. Recognizing this, the tax authorities who have implemented fiscal till schemes have made it illegal to not issue a sales receipt. But illegality doesn't seem to me like a big hindrance to a retailer who has already set their mind on evading taxes.

One neat trick to get retailers to provide receipts—and therefore run all transactions through the tamper-proof cash register—is to recruit the customer into the cat and mouse game as helper. Public information campaigns exhorting people to ask for receipts are one technique. But the more interesting trick is implementing a tax-receipt lottery. All invoices issued from the tamper-proof cash register come with a unique lottery number. Anyone who keeps their invoices will be able to participate in a periodic lottery. Customers thus have an incentive to ask the retailer for a receipt, obliging the retailer to run the transaction through the fiscal till.

Taiwan implemented the first tax receipt lottery back in the 1950s, the Uniform Invoice lottery. I've included a picture below, and here is the website. In the last fifteen years, a number of nations have begun to copy it including Czech, Slovakia, Slovenia, Malta, Portugal, Poland, China, Sao Paulo, and Lithuania.

Taiwan sales receipts with lottery numbers on them

The next stage of the cat and mouse game occurs as the retailer, desperate to adapt to the government's crafty invoice lottery, tries to coax the customer over to his side. On a $50 meal, a restaurant may be able to save $2.50 in tax (assuming a 5% tax rate) if the the fiscal till is avoided. If the restaurateur says that he will share some of this savings with the customer, he may be able to induce her to not ask for an invoice and thus avoid the till. The amount of money he must dangle in front of her will have be large enough to compensate her for the foregone fun of playing the lottery, potential lottery winnings, and guilt.

China is the most interesting example of the cat and mouse game being played at this level. To incentivize cash-paying customers to ask for invoices, or fapiao, the Chinese authorities have created a scratch and win game. Restaurateurs have reacted by offering customers a free soda, or a discount, if they don't ask for the fapiao. Presumably the value of a soda is just sufficient to compensate the customer for foregoing the lottery. More entertaining accounts of fapiao here and here

I'm sure these methods of attacking tax avoidance work to an extent. In Québec, for instance, as of March 2016 the tax authorities say that they have recovered CAD$1.2 billion in taxes following the introduction of fiscal tills in the restaurant industry. However, I'll hazard that the biggest determinant of tax avoidance is good government. If people trust the government to do smart things with tax revenues and they don't see evidence of corruption, then they will be more likely to view paying taxes and reporting on cheaters as one of their public duties.

Other sources:
OECD: Technology Tools to Tackle Tax Evasion and Tax Fraud (link)
Ainsworth: Québec’s Sales Recording Module (SRM) - Fighting the Zapper, Phantomware, and Tax Fraud with Technology (link)
Steenbergen: Reaping the benefits of Electronic Billing Machines (link)

Tuesday, January 30, 2018

The big ol' €500

Production of the European Central Bank's €500 notes is scheduled to come to an end later this year. But a chart of the quantity of €500 banknotes in circulation (see below) reveals something odd. The supply of €500s began to plummet way back in early 2016, long before note production was supposed to be halted. What gives?

It was back on May 4, 2016 that the ECB officially announced that it would stop printing and issuing the €500 note, one of the world's most valuable banknotes ranked by purchasing power. The reason it gave was concerns that the €500 "could facilitate illicit activities." You may remember that this was in the midst of ex-banker Peter Sands screed against high denomination notes, echoed by economist Larry Summers and later amplified by Ken Rogoff's book The Curse of Cash.

While the €500 is undoubtedly popular with organized crime, there is some evidence that regular people use €500s, as Larry White points out here. In the recently published survey on the use of cash by households in the euro area, 19% of respondents reported having a €200 or €500 in their possession in the previous year. A quarter of respondents held banknotes (they don't specify the denomination) as a precautionary reserve, with 12% of these reporting a stash greater than €1000. So that means that around 3% of Europeans keep a large hoard of notes under their mattresses. This presumably gives the €500 a role to play as a store of value. After all, hiding thirty €500s under the bed is more convenient than three-hundred €50s.

But concerns over illicit usage of the €500 won out. Issuance of new €500s is set to stop near the end of 2018, although after that date people will be free to continue holding existing €500s as a store of value or to buy things. Any note deposited in the banking system after that point will be sent to the ECB to be destroyed. With no new supply and a steady removal of existing €500 notes, the quantity outstanding after 2018 will steadily shrink.

Below, I've charted out the total value of euro high denomination banknotes in circulation.

Although the €500 has eight or nine months left before this deadline is reached, the supply has already fallen by around €50 billion from its peak level of €300 billion outstanding in January 2016. Has the ECB jumped the gun and already kiboshed the €500 without telling anyone?

Luckily, the ECB provides incredibly fine-grained data on banknotes. Not only can we get the total value of banknotes in circulation, but also the monthly flow of banknotes issued by the ECB to private banks and returned by private banks. I've charted these flows below.

No, the ECB has not jumped the gun. It continues to issue several billion euros worth of €500s each month (the black line). But whereas issuance tended to exceed note returns in the past—the result being growth in the total stock of €500s in circulation—the tables have turned and note returns (the grey line) have generally exceeded issuance since early 2016, and thus the stock has dwindled. So the observed decline in the supply of €500s is entirely the result of the public's preference to have less of them.

This highlights an important point that I often mention on this blog. One of the most popular motifs of central banks is that they print cash willy nilly, forcing it onto an unsuspecting and virginal economy. This wildly misses the mark. Central banks do not push banknotes into the economy. Rather, the public pulls banknotes out of the central bank into the economy and pushes them back to the central bank. Each month Europeans return whatever quantity of €500s they don't want to the banking system, commercial banks in turn forwarding this currency to the ECB. Others withdraw whatever amounts of €500s they desire from their bank accounts, private banks in turn calling on the ECB to provide sufficient €500s. The net effect is an increase or decrease in the total stock of €500 banknotes in circulation. The ECB itself has no direct control over the public's decision to build or diminish the total supply of €500s.

I suspect that the relatively large increase in €500 note returns since 2016 is due to worries of an aggressive demonetization. As the second chart shows, returns of €500s began to accelerate in February and March 2016, well before the May 2016 announcement date. At the time, hints of the €500's imminent demise were being leaked to the press. Now, imagine that you are the head accountant at a large criminal organization with multiple suitcases full of €500s. You are hearing rumours that something is about to be done to the €500 note. The worst case scenario is that the note is to be suddenly cancelled—or demonetized—by the ECB, the period for converting €500s into €100s and €200s limited to a harrying few weeks. If the conversion window is being monitored by the authorities, your organization's attempts to convert €500s into smaller denominations might be flagged for further inspection.

Given this scenario, you'd want to change your suitcases full of €500s into €100 and €200s as fast as possible, before the actual announcement hits. Otherwise your organization might end up forfeiting a large chunk of the value of those notes—and you might be fired, literally. So my guess is that the rumours surrounding the fate of the €500 probably caused a mini "banknote run" in the months prior to the May announcement. Even after the ECB assuaged worries about an aggressive demonetization by promising to exchange €500s for an unlimited period of time, note returns have remained high relative to issuance. This suggests that the underground market still has worries about a potential aggressive demonetization, and are shifting into safer alternatives.

Once the ECB stops issuing €500s at the end of this year, the pull-push mechanism I described above will cease to function. There are two ways to set monetary policy. The first way—the one that regulates all banknotes including the €500—is to fix the price and let the quantity fluctuate as the public pulls what it needs and pushes back what it doesn't. The other policy is to fix the quantity and let the price fluctuate. This is the policy governing assets like gold, or the S&P 500, or bitcoin. 

After 2018 the ECB will have switched from fixing the price of €500s to fixing their quantity. At that point, the price will become a floating one determined by public demand, just like gold or bitcoin or the S&P 500. The higher the public's demand for €500s, the more its price will rise relative to pegged banknotes like the €100. A few years from now, it might take six or seven €100s to buy one €500.

Thursday, January 25, 2018

Paying interest on cash

Freigeld, or stamp scrip, is designed to pay negative interest, but it can be re-purposed to pay positive interest.

Remember when global interest rates were plunging to zero and all everyone wanted to talk about was how to set a negative interest rate on cash? Now that interest rates around the world are rising again, here's that same idea in reverse: what about finally paying positive interest rates on cash? I'm going to explore three ways of doing this. As for why we'd want to pay interest on cash, I'll leave that question till the end.


The first way to pay interest on cash is to use stamping. Each Friday, the owner of a bill—say a $50 note—can bring it in to a bank to be officially stamped. The stamp represents an interest payment due to the owner. When the owner is ready to collect his interest, he deposits the note at the bank. For example, say that 52 weeks have passed and 52 stamps are present on the $50 note. If the interest rate on cash is 5%, then the banknote owner is due to receive $2.50 in interest.

Alternatively the note owner can collect the interest by spending the $50 note, say at a local grocery store. The checkout clerk will count the number of stamps, or interest due, and tack that on to the face value of the note. With 52 stamps, the owner of a $50 note should be able to buy $52.50 worth of groceries, not $50. After all, the store has the right to bring the $50 note to its bank and collect the $2.50 in interest for itself.

Stamped currency seems like a pretty big hassle to me. The clerk behind the counter must count out the stamps on the note by hand, and the owner of the note has to trek back and forth to the bank each week to get the stamp affixed. Instead, imagine that each banknote has a magnetic strip that records how long the bill had been in circulation. This would remove some of these hassles. Weekly trips to the bank for stamping would no longer be necessary, and a note reader installed at a bank or retailer would automatically record how much interest was due, precluding painstaking counting of stamps.

"They use this magnetic strip to track you." says Byers to Agent Scully, The X-Files

Apart from stoking conspiracy theories, there's still a major problem with a magnetic strip scheme. Because each note has entered circulation at a different time, each is entitled to a varying amounts of interest. And this means that banknotes are no longer fungible. Fungibility—the ability to cleanly interchange all members of a population—is one of the features of money that makes it so easy to use. Remove it and money becomes complicated, each piece requiring a unique and costly effort to ascertain its value.


Our second way of paying interest on money doesn't destroy the fungibility of banknotes. The central bank needs to sever the traditional 1:1 peg between deposit money and cash, and then have cash slowly appreciate in value relative to deposits.

For instance, a central bank might start by setting an exchange rate of $1 note = $1 deposit on January 1, but on January 2 it adjusts this rate so $1 note is equal to $1.0001 deposits, and on January 3 adjust this rate to $1:$1.0002, etc. So the cash in your wallet is benefiting from capital gains. By December 31, the exchange rate will be around $1 note to $1.0365. Anyone who has held a banknote for the full year can deposit it and will have earned 3.65 cents in interest, or 3.65%. 

The major drawback with this scheme is the calculational burden imposed on the population by breaking the convenient 1:1 peg between cash and deposits. Assuming that retailers price their wares in terms of deposits, anyone who wants to pay in cash will have to make a currency conversion using that day's exchange rate. For instance, if the central bank's peg is currently being set at $1 note = $1.50 in deposits, then a popsicle that is priced at $1 will require—hmmm... let me check my calculator—$0.667 in cash. Phones will make this exchange rate calculation easy, but it is still likely to be a bit of a nuisance.

There are other hassles too. Would a capital gains tax have to be paid on the appreciation of one's cash? How would existing long-term contracts deal with the divergence? For instance, if my employer is paying me $50,000 per year, obviously I'd prefer this sum be denominated in steadily appreciating cash rather than constant deposits, and she will prefer the latter. What becomes the standard unit of account?


The last way to pay interest (at least as far as I know) is to run lotteries based on banknote serial numbers, an idea independently proposed by Hu McCulloch and Charles Goodhart back in 1986.

Central banks would periodically hold draws entitling the winning serial numbers to large cash prizes. For example, if there was $100 billion in banknotes in circulation, the central bank could set the interest rate on cash at 5% by offering prizes over the course of the year amounting to 5% of $100 billion, or $5 billion.

This technique of paying interest on cash solves the fungibility problem that plagues the earlier stamping technique. Every note has the same chance of winning the lottery, and non-fungible winners are immediately withdrawn. And unlike the crawling peg idea, banknotes and deposits remain equal to each other so burdensome exchange rate calculations don't need to me made.

However, it introduces the threat of bank runs. The day before the big lottery is set to occur, everyone will withdraw deposits for cash so that they can compete in the draw. To prevent a bank run, it may be necessary to randomize the date of the big lottery so that no one knows when to withdraw notes, an idea proposed by Tyler Cowen. Another way to preclude bank runs is to have a regular stream of small weekly lotteries rather than one or two big ones each year.

Another drawback to note lotteries is the cost that is imposed on society by having everyone constantly checking serial numbers. As Brian Romanchuk points out, employees who are working behind their employer's tills may be tempted to switch out winning notes with losers. Employers may protect themselves by setting up scanning hardware to read in serial numbers as banknotes enter the tills, maintaining their own internal database of cash inventories so that winners can quickly be isolated and returned. But all of that is costly. Would it be worth it?

Interestingly, there is some precedent for these sorts of lotteries. In Taiwan, receipts are eligible for a receipt lottery, a neat way to incentivize people to avoid under-the-table transactions (ht Gwern). Lotteries can also be useful in attracting depositors, as outlined in this Freakonomics podcast (ht Ryan). George Selgin and William Lastrapes have gone into the idea of lottery-linked money in some detail:
Though the suggestion may appear far fetched, in many countries lotteries are presently being used with considerable success to market bank deposits. According to Mauro Guillen and Adrian Tschoegl (2002), “lottery-linked” deposit accounts have been especially popular with poorer persons, including many who might otherwise remain “outside the banking system.” ... In two popular Argentine schemes, for instance, depositors receive one ticket or chance of winning for every $200 or $250 on deposit (ibid., p. 221). Lottery-linked banknotes, in contrast, would themselves serve as tickets, allowing persons to play for as little as the value of the lowest note denomination, and with no apparent cost to themselves save that of occasionally inspecting their note holdings.

Some readers may recognize these three techniques for paying interest on cash as the inverse of the three go-to ways of applying negative interest rates to cash being discussed a few years ago. For instance, one of the most well-known ways of imposing negative interest rates on owners of cash is to apply a Silvio Gesell style stamp scheme (see picture at top), whereby a currency owner must buy a stamp and affix it to the note in order to renew the validity of their currency each month. (I once discussed Alberta's experiment with Gesell's "shrinking money" here). Without the appropriate number of stamps, the note is illegitimate. In my first example above, Gesell's stamp tax has been re-engineered into a stamp subsidy. As for the magnetic strip modification, this is Marvin Goodfriend's 1999 update of Gesell, flipped around to award interest rather than docking it.

Miles Kimball has written extensively on escaping the zero lower bound to interest rates by setting a crawling peg on currency. But just as Kimball's crawling peg can impose a negative interest rate on banknotes, it can be used to pay interest, as I described above. Indeed, Miles (along with Ruchir Agarwal) frequently mention this possibility in his blog posts and papers (see this pdf).

Finally, remember Greg Mankiw's controversial 2009 article on imposing negative interest rates by serial number? He wrote:
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
Mankiw's idea is just the reverse of Goodhart and McCulloch's earlier lottery idea, the lottery replaced by with a demonetization.


So why pay interest on currency? I can think of two reasons. One is based on fairness, the other on efficiency.

The decision to avoid paying the market rate of interest on currency amounts to a tax on currency users. Who pays this tax? Cash is often the only means for the poor, new immigrants, and unbanked to participate in the economy. So the tax falls on those who can least afford it. This hardly seems fair. By conducting note lotteries or stamping notes, those consigned to the cash economy can get at least the same return on banknotes as the well-off banked receive on deposits.

Now hold up JP, some you will be saying at this point. What about criminals? Yep, the other group of people who suffer from the lack of interest on banknotes are criminals and tax evaders. Rewarding them with interest hardly seems appropriate. One would hope that if central banks did adopt a mechanism for rewarding currency with interest, it would be capable of screening out bad actors. For instance, criminals may be leery of collecting their interest or lottery prize if making a claim at a bank means potentially being unmasked. Another way to set up the screen would be to pay interest or prizes on small denominations like $1-$10 notes, and not on $20s and above. Since criminal organizations prefer high denomination notes due to their compactness, they wouldn't benefit from interest.

As for the efficiency argument, this is nothing but the famous Friedman rule that I described in my previous post. All taxes impose a deadweight loss on society. When a good or service is taxed, people produce and consume less of it than the would otherwise choose, tax revenues not quite compensating for this loss. From a policy maker's perspective, the goal is to reduce deadweight loss as much as possible by selecting the best taxes.

In the case of cash, the deadweight loss comes from people holding less of it than they would otherwise prefer, incurring so-called shoe leather costs as they walk to the bank and back to avoid holding too much of the stuff. If a 0% return on cash is an inefficient form of taxation relative to other alternatives types of taxes, then it would be better for the government to just pay interest on the stuff and recoup the lost revenues elsewhere, say through consumption taxes or income taxes.

Sunday, January 14, 2018

Floors v corridors

David Beckworth argues that the U.S. Federal Reserve should stop running a floor system and adopt a corridor system, say like the one that the Bank of Canada currently runs. In this post I'll argue that the Bank of Canada (and other central banks) should drop their corridors in favour of a floor—not the sort of messy floor that the Fed operates mind you, but a nice clean floor.

Floors and corridors are two different ways that a central banker can provide central banking services. Central banking is confusing, so to illustrate the two systems and how I get to my preference for a floor, let's start way back at the beginning.

Banks have historically banded together to form associations, or clearinghouses, a convenient place for bankers to make payments among each other over the course of the business day. To facilitate these payments, clearinghouses have often issued short-term deposits to their members. A deposit provides clearinghouse services. Keeping a small buffer stock of clearinghouse deposits can be useful to a banker in case they need to make unexpected payments to other banks.

Governments and central banks have pretty much monopolized the clearinghouse function. So when a Canadian bank wants to increase its buffer of clearinghouse balances, it has no choice but to select the Bank of Canada's clearing product for that purpose. Monopolization hasn't only occurred in Canada of course, almost every government has taken over their nation's clearinghouse.

One of the closest substitutes to Bank of Canada (BoC) deposits are government t-bills or overnight repo. While neither of these investment products is useful for making clearinghouse payments, they are otherwise identical to BoC deposits in that they are risk-free short-term assets. As long as these competing instruments yield the same interest rate as BoC deposits, a banker needn't worry about trading off yield for clearinghouse services. She can deposit whatever quantity of funds at the Bank of Canada that she deems necessary to prepare for the next day's clearinghouse payments without losing out on a better risk-free interest rate elsewhere.  

But what if these interest rates differ? If t-bills and repo promise to pay 3%, but a Bank of Canada deposit pays an inferior interest rate of 2.5%, then our banker's buffer stock of Bank of Canada deposits is held at the expense of a higher interest elsewhere. In response, she will try to reduce her buffer of deposits as much as possible, say by reallocating bank resources and talent to the task of figuring out how to better time the bank's outgoing payments. If more attention is paid to planning out payments ahead of time, then the bank can skimp on holdings of 2.5%-yielding deposits while increasing its exposure to 3% t-bills.

Why might BoC deposits and t-bills offer different interest rates? We know that any differential between them can't be due to credit risk—both instruments are issued by the government. Now certainly BoC deposits provide valuable clearinghouse services while t-bills don't. And if those services are costly for the Bank of Canada to produce, then the BoC will try to recapture some of its clearinghouse expenses. This means restricting the quantity of deposits to those banks that are willing to pay a sufficiently high fee for clearing services. Or put differently, it means the BoC will only provide deposits to banks that are willing to accept an interest rate that is 0.5% less than the 3% offered on t-bills.

But what if the central bank's true cost of providing additional clearinghouse services is close to zero? If so, the Bank of Canada should avoid any restriction on the supply of deposits. It should provide each bank with whatever amount of deposits it requires without charging a fee. With bankers' demand for clearing services completely sated, the differential between BoC deposits and t-bills will disappear, both trading at 2.5%.

There is good reason to believe that the cost of providing additional clearinghouse services is close to zero. It is no more costly for a central bank to issue a new digital clearinghouse certificate than it is for a Treasury secretary or finance minister to issue a new t-bill. In both cases, all it takes is a few button clicks.

Let's assume that the cost of providing clearinghouses is zero. If the Bank of Canada chooses to  constrain the supply of deposits to the highest bidders, it is forcing banks to overpay for a set of clearinghouse services which should otherwise be provided for free. In which case, the time and labour that our banker will need to divert to figuring out how to skimp on BoC deposit holdings constitutes a misallocation of her bank's resources. If the Bank of Canada provided deposits at their true cost of zero, then her employees' time could be put to a much better use.

As members of the public, we might not care if bankers get shafted. But if our banker has diverted workers from developing helpful new technologies or providing customer service to dealing with the artificially-created problem of skimping on deposits, then the public directly suffers. Any difference between the interest rate on Bank of Canada deposits and competing assets like t-bills results in a loss to our collective welfare.


Which finally gets us to floors and corridors. In brief, a corridor system is one in which the central bank rations the number of clearinghouse deposits so that they aren't free. In a floor system, unlimited deposits are provided at a price of zero.

When a central bank is running a corridor system, as most of them do, the rate on competing assets like t-bills lies above the interest rate on central bank deposits. Economists describe these systems as corridors because the interest rate at which the central bank lends deposits lies above the interest rate on competing safe assets like t-bills and repo, and with the deposit rate lying at the bottom, a channel or corridor of sorts is formed.

For instance, take the Bank of Canada's corridor, illustrated in the chart below. The BoC lets commercial banks keep funds overnight and earn the "deposit rate" of 0.75%. The overnight rate on competing opportunities—very short-term t-bills and repo—is 1%. The top of the corridor, the bank rate, lies at 1.25%. So the overnight rate snakes through a corridor set by the Bank of Canada's deposit rate at the bottom and the bank rate at the top. (The exception being a short period of time in 2009 and 2010 when it ran a corridor floor).

Let's assume (as we did earlier) that the BoC's cost of providing additional clearinghouse services is basically zero. Given the way the system is set up now, there is a 0.25% rate differential (1%-0.75%) between the deposit rate and the rate on competing asset, specifically overnight repo. This means that the Bank of Canada has capped the quantity of deposits, forcing bankers to pay a fee to obtain clearing services rather than supplying unlimited deposits for free. This in turn means that Canadian bankers are forced to use up time and energy on a wasteful effort to skimp on BoC deposit holdings. All Canadians suffer from this waste.

It might be better for the Bank of Canada (and any other nation that also uses a corridor system) to adopt what is referred to as a floor system. Under a floor system, rates would be equal such that the rate on t-bills and repo lies on the deposit rate floor of 0.75%--that's why economists call it a floor system. The Bank of Canada could do this by removing its artificial limit on the quantity of deposits it issues to commercial banks. Banks would no longer allocate scarce time and labour to the task of skirting the high cost of BoC deposits, devoting these resources to coming up with new and superior banking products. In theory at least, all Canadians would be made a little better off. All the Bank of Canada would have to do is click its 'create new clearinghouse deposits'  button a few times.


The line of thought I'm invoking in this post is a version of an idea that economists refer to as the optimum quantity of money, or the Friedman rule, first described by Milton Friedman back in the 1960s. Given that a central bank's cost of issuing additional units of money is zero, Friedman thought that any interest rate differential between a monetary asset and an otherwise identical non-monetary asset represents a loss to society. This loss comes in the form of people wasting resources (or incurring shoe leather costs) trying to avoid the monetary asset as much as possible. To be consistent with the zero cost of creating new monetary assets, the rates on the two assets should be equalized. The public could then hold whatever amount of the monetary asset they saw fit, so-called shoe leather costs falling to zero.

In my post, I've applied the Friedman rule to one type of monetary asset: central bank deposits. But it can also be applied to banknotes issued by the central bank. After all, banknotes yield just 0% whereas a t-bill or a risk-free deposit offers a positive interest rates. To avoid holding large amounts of barren cash, people engage in wasteful behaviour like regularly visiting ATMs.

There are several ways to implement the Friedman rule for banknotes. One of the neatest ways would be to run a periodic lottery that rewards a few banknote serial numbers with big winnings, the size of the pot being large enough that the expected return on each banknote as made equivalent to interest rate on deposits. This idea was proposed by Charles Goodhart and Hugh McCulloch separately in 1986.

Robert Lucas once wrote that implementing the Friedman rule was “one of the few legitimate ‘free lunches’ economics has discovered in 200 years of trying.” The odd thing is that almost no central banks have tried to adopt it. On the cash side of things, none of them offer a serial number lottery or any of the other solutions for shrinking the rate differential between banknotes and deposits, say like Miles Kimball's more exotic crawling peg solution. And on the deposit side, floor systems are incredibly rare. The go-to choice among central banks is generally a Friedman-defying corridor system.

One reason behind central bankers' hesitation to implement the Friedman rule is that it would threaten their pot of "fuck you money", a concept I described here. Thanks to the large interest rate gaps between cash and t-bills, and the smaller gap between central bank clearinghouse deposits and t-bills, central banks tend to make large profits. They submit much of their winnings to their political masters. In exchange, the executive branch grants central bankers a significant degree of independence... which they use to geek out on macroeconomics. Because they like to engage in  wonkery and believe that it makes the world a better place, central bankers may be hesitant to implement the Friedman rule lest it threaten their flows of fuck you money, and their sacred independence. 

That may explain why floors are rare. However, they aren't without precedent. To begin with, there is the Fed's floor that Beckworth describes, which it bungled into by accident. At the outset of this post I called it a messy floor, because it leaks (George Selgin and Stephen Williamson have gone into this). The sort of floor that should be emulated isn't the Fed's messy one, but the relatively clean floor that the Reserve Bank of New Zealand operated in 2007 and Canada did from 2009-11 (see chart above). Though these floors were quickly dropped, I don't see why the couldn't (and shouldn't) be re-implemented. As Lucas says, its a free lunch.

Wednesday, January 10, 2018

XRP and bitcoin as bridge currencies

Eshima Ohashi Bridge, Japan

The value of all outstanding XRPs recently surpassed that of bitcoin, hitting $300 billion or so last month. XRPs are a cryptocurrency issued by Ripple, a company that is trying to shake up the business of cross border payments. Ripple has a number of strategies for doing this, but the one that has caught people's imaginationespecially as the price of XRPs rocket higheris to have banks and other financial institutions use XRP as a 'bridging asset' for moving value across borders. The idea of using a cryptocurrency as a bridge isn't a new idea. Bitcoin remittance companies have been trying to do this for several years now, without very much success.

So what do I mean by using a cryptocurrency like bitcoin or XRP as a bridge asset? Does it make any sense? To answer these questions, let's dissect a hypothetical cross border payment.

Straddling two universes

As users of banks and other financial institutions, we rarely think about what is going on underneath the hood of a money transfer. If I send money from my account to yours, the language of this transaction implies that money is flowing from my bank account to bank account. But moving funds from one bank to another bank is physically impossible. If my account is at Bank A, and yours is at Bank B, I cannot send value directly from my account to your account. Our two accounts may as well exist in entirely separate universes.

The only way I can make a bank-to-bank payment to you is indirectly, by turning to a third-party who straddles both universes. Say my hair dresser has accounts at both my bank and your bank, and for a small fee she'll do the transaction for us. I tell my bank (Bank A) to credit my hairdresser's account at Bank A by $10, and my hair dresser in turn tells her bank (Bank B) to debit her account and credit you account at Bank B by $10. The payment is done. I have $10 less, you have $10 more, and my hair dresser is flat, her $10 having been erased from Bank B's ledger with a new $10 deposit appearing in her account at Bank A.

The same principle is at work in cross border payments, except the person who is doing the straddling between the two bank—my hair dresserwill need to have a domestic bank account, say in Canada, and an international account, say Philippines. And instead of crediting you $10, she will have her Filipino bank send you the peso equivalent of $10, which is around ₱400 at the current 40:1 exchange rate. But apart from that, the concept is the same.

In principle, a cross border payment like this could go very fast. Assuming that it only takes the Canadian bank a few moments to transfer $10 from my account to my hair dresser's account, then she can quickly start the Philippines leg of the transaction. And if the Filipino bank is just as fast, you'll have the ₱400 just a few moments after she clicks the send button. This whole chain needn't take more than twenty minutes of fiddling with bank websites.

The benefits of queues

But there are factors militating against speed. Say that I need to send you money several times a day. It would be a hassle for my hair dresser to log in to her Philippines bank account and process each payment as it arrives in her Canadian accountshe has to cut hair, after all. Instead, she chooses to wait till the end of the day when several of my payment requests have accumulated, upon which she batches the payments into one large payment and clicks the send button.

There is a trade-off here between speed and cost. Putting transaction requests into a queue slows down each of my payments to you, but it imposes less costs on my hair dresser. Slow speeds aren't necessarily a bug. If we all want to save some money, sluggishness may be the best solution for all of us.

Pre-funding: expensive but speeds things up

Imagine that over the course of a few weeks I make so many payments to you that my  hairdresser's Filipino account runs out of funds. When this happens she will no longer be able to make outgoing payouts to your Philippines bank account. To keep the system up and running, she will have to replenish her account with pesos. One of her options would be to withdraw cash from her Canadian account, fly it to Philippines in a suitcase, trade it at the airport for peso banknotes, and deposit these into her Filipino account. This would be slow, expensive, dangerous, and potentially illegal, but it's a theoretical option.

A more realistic option would be to sell her Canadian dollar deposits to a foreign exchange dealer and get Filipino peso deposits in return. This dealer, who will have accounts in both Philippines and Canada, will execute this trade for a commission. My hairdresser will have to ask her Canadian bank to credit the dealer's dollar account while the dealer asks his Filipino bank to credit my hair dresser's peso account. There will be some lag as the dealer processes the transaction, say because helike my  hairdresseruses a queue to batch payments together so as to save on fees. But once my hair dresser's Filipino account has been topped up, I can once again make payments to you.

Instead of allowing her Filipino account to periodically run down to zero, my hairdresser may try to maintain a permanently-funded peso account. After all, if she doesn't prefund the account, then you and I will have to cope with constant delays as she waits for the foreign exchange dealer to refill her account. Prefunding her Philippines account isn't without  cost, however. Instead of being able to invest the money in bonds or upgrading her salon, my hair dresser must tie her capital up in a low-yielding bank account as she awaits my payments requests.

Thus, as in the case of queuing on the Canadian side, prefunding on the Philippines side involves a trade-off between cost and efficiency. Reducing the amount of pesos held in anticipation of incoming payment request will allow my hairdresser to reduce costs, but it will simultaneously slow down payments from you to me since the odds of having to wait for a refill increase.

To sum up, for cross border payments to occur someone must straddle the divide between isolated banks. This straddler uses techniques like queuing and prefunding in order to make cross border payments proceed as fast as possible without costing too much.

Cryptocurrency as a bridge

So where do XRP and bitcoin come in? The two of us want little more than a flow of recurring peso payments to arrive in your Filipino bank account as fast and cheaply as possible, but what goes on underneath the hood doesn't concern us. If she can increase payment speeds without having to pay a higher cost (or, alternatively, if she can reduce costs without sacrificing speed), it may make sense for my hairdresser to incorporate an asset like XRP or bitcoin in the payments process.

Say at the end of Monday my hair dresser has amassed four $10 payments in her queue, or $40. She logs into her Filipino bank account, and sends you one ₱1600 payment. She wants to rebuild her Filipino account balance in preparation for the rest of the week's incoming payments. Normally she would do so by asking her foreign exchange dealer to swap her some Filipino deposits for her Canadian dollar deposits.

Instead, she decides to pre-fund by turning to the market for cryptocurrencies. One option is to take the $40 I've transferred her and buy $40 worth of XRPs from her foreign exchange dealer, then sell these XRPs to another dealer for ₱1600 in deposits. Alternatively, she may turn to an organized exchange to complete the refunding. She sends the $40 to a Canadian cryptocurrency exchange, buys some bitcoin or XRP, quickly sends these coins to a Filipino cryptocurrency exchange, and then sells them for pesos. At which point she will transfer the pesos to her bank. Voila, her Filipino bank account has been reloaded using cryptocurrency as a bridge.

Comparing fees and speed

Let's compare these two routes. By exchanging dollars directly for pesos via a foreign exchange dealer, only one transaction had to be completed, and thus one set of hassles and fees incurred. By going through the cryptocurrency market, my hairdresser must make two transactionsa purchase of XRP or bitcoin on the Canadian crypto exchange (or from a dealer) using Canadian dollars, and a sale of XRP/bitcoin on the Filipino crypto exchange (or to a dealer) for pesos. If the sum of these two sets of hassles and fees is less than the traditional single set of hassles and fees, then going the cypto route may make some sense for her. But I confess that I think it is highly unlikely that two sets of fees beat one.

It could very well be quicker for my hair dresser to reload her Filipino account via XRP/bitcoin than the traditional route. For instance, the dealer who is buying her Canadian dollars and selling her pesos may delay the peso leg of the transaction for twenty-four hours. But this sluggishness isn't inherent to a fiat-to-fiat transfer. If she asks nicely, there is no reason the dealer can't expedite the transaction so that the pesos appear in her account within the hour. By queuing her request with many others over a twenty-four hour period the dealer reduces his overall costs, these benefits flowing back to my hair dresser in the form of reduced fees. Likewise, my hair dresser could choose to queue her XRP/bitcoin payment into a big chunk along with other people's cryptocurrency payments. This would slow things down, but reduce fees.

US dollars a bridge currency

Not all traditional cross border payments involve one transaction. Canada-Philippines is a relatively popular payments route, but rarely used payments corridors, say like Canada to Uzbekistan, will incorporate a third fiat currency—probably U.S. dollarsas a bridge currency. For this payment to proceed, my hairdresser will need both a Canadian dollar account and a U.S. dollar account. She will have to find a counterpart who straddles the U.S. and Uzbek banking systems by maintaining a U.S. dollar account and an Uzbekistani Som account. Once she transfers her counterpart some U.S. dollars, then he can execute the Uzbek leg of the payment.

Even on exotic corridors I have troubles seeing how XRP/bitcoin can compete as a bridge. The dollar is the world's most entrenched currency. The CADUSD market will always be deeper than the XRP-to-CAD or bitcoin-to-CAD market, and same on the Uzbek Som side. This depth means that transaction costs on U.S. dollar trades will be lower than on crypto trades. For this calculus to change, bitcoin or XRP will somehow have to displace the U.S. dollar as the world's most liquid medium of exchange. But this is unlikely to happen due to the incredible volatility of cryptocurrencies.


Which leads into the next defect of crytocurrencies as bridge assets. XRP and bitcoin are inherently volatile assets, so using crypto as a bridge means the risk of encountering a plunge in value.  In the case of XRPs, my hairdresser will have to hold them for at least a few moments (or even minutes), but that could be enough time to cause some damage. As for bitcoin, which is slower, she will have to carry them for an hour or two before they can be sold in Philippines. That's an eternity in cryptoland. To top it off, crypto exchanges are notoriously risky, outages and thefts being a regular occurrence. These are pretty big risks for my hair dresser to take, so using crypto markets will only make sense if they provide her enough compensating efficiencies.

Where might these come from? Traditional cross border payments have typically offered very little in the way of transparency. If my hair dresser's payment is stuck, it'll be hard for her to get information on its status. To cope with this informational gap, she may choose to constantly over-fund her peso account, which hurts her pocket book. One advantage of something like Ripple is that all XRPs are recorded on the public Ripple ledger, and thus my hair dresser should have a better idea about what stage her payment has progressed. And this may give her the confidence to reduce the amount by which she pre-funds her peso account, the freed up capital being invested in her salon.

That's a nice feature, but I don't quite see how increased transparency can possibly make up for 1) the inherent risks of holding cryptocurrencies, even if just for a few moments, and 2) the aforementioned transactions costs involved in running the bridge. Furthermore, the transparency advantage is being eroded as traditional payments systems respond to the competitive threat posed by players like Ripple. SWIFT, the communications network that is relied on to facilitate traditional cross border payments, has recently incorporated a tracking number to all payments, thus allowing users to get a real-time end-to-end view on the status of their payments.

So for now, I don't think there is much merit to using crypto as currency bridge in cross border payments. That doesn't mean XRP must crash because it has no use case. Dogecoina parody cryptocurrency that recently rose above $1 billion in valuedemonstrates that coins don't need a fundamental use case to justify their price. But I've been wrong many times about cryptoland, so let's see what happens.

Tuesday, December 19, 2017

Money as a generally-accepted medium for short selling

Jim Chanos, famous short seller. We are all Jim Chanos.

Most people find the idea of short-selling to be incomprehensible. Buy a stock and hold it, that's what one does. To the majority of us it's just down-right odd to do the reverse, borrow stock in order to sell.

At the same time, pretty much everyone in the world is a short seller, even if we don't realize it. The credit card debt we wrack up, the lines of credit, the pay day loans, the mortgages—they're all examples of us going short. We borrow a certain type of security—dollars or yen or other types of money, either in paper or digital format—and immediately sell it. And then after a little time passes we cover that short, buying the dollars or yen back and repaying the loan. We are all Jim Chanos, the world's most famous short seller, the only difference being we tend to short different instruments than Chanos does.

The only time I ever sold a stock short was back in 1999. I was still in university and probably a little bit reckless. What I didn't know at the time was that there was still a year or so left in the crazy late 1990s bull market. The price of the stock that I had shorted immediately began to move higher, and I got worried. The problem with short selling is that because a stock can keep rising forever, losses are theoretically infinite. After a month or two I bought the stock back to cover the loan, then got back to my studies.

While I've only sold stock short once, I've sold money short umpteen times. Borrow some Canadian dollars, sell it for things like groceries or a plane ticket or tuition, wait a while, repurchase the money, pay the loan back.

So why don't I finance my consumption by shorting things like Netflix or bitcoin? Why do I short dollars instead?

The nice thing about shorting money rather than Netflix shares or bitcoins is that I know exactly how much it'll cost me to repurchase the necessary securities to cover my short. Our labour is almost always priced in term of money, say $30 per hour. So if I've shorted three one-hundred dollar bills, I know ahead of time that I only need to sell ten hours of my time to buy that $300 back.

What's more, labour tends to stay sticky for months. This means I don't have to worry about my per-hour rate plunging temporarily to $15 next Wednesday, forcing me to spend twenty hours of time instead of just ten to cover my short. And since the central bank sets an inflation target of 2% or so a year, I already know far ahead of time that if I'm making $30 per hour this year, I'll be making ~$30.60 next year. So whereas one hour of my labour allowed me to cover a $30 short position in 2017, that same hour will allow me to cover a $30.60 short position in 2018. That sort of long-term certainty is a great feature.

Not so with bitcoin or Netflix. The big problem with using these instruments to finance consumption is that labour is never paid in terms of bitcoin or Netflix, but in yen or dollars or pounds. So while the sticky nature of labour means I know ahead of time that I'll be able to sell an hour of my time for $30, I don't know how many bitcoins or Netflix shares this $30 will allow me to repurchase to cover my bitcoin/Netflix shorts. This would be less of a problem if Netflix and bitcoin were fairly stable in price, but both are terrifically volatile, as I described here.

Consider a scenario in which I short one share of Netflix in order to fund my weekly supply of groceries (which costs ~$200)—or alternatively I short 0.01 bitcoins—and the price of either of these two assets doubles over the next few days. I'll end up having to pay $400 to cover the short, or fourteen hours of labour. If I had just shorted $200 dollars instead, I'd only owe seven hours ($200/$30).

A worst case scenario is one in which Netflix of bitcoin start to rise to infinity. If so, I'd have to work every waking hour of my life just to repurchase Netflix/bitcoin and cover my short. No thanks, I'll take the predictability of shorting money to pay for $200 worth of groceries. Central banks can create and cancel whatever amount of money they need to keep the purchasing power of money on a narrow path. I'll never have to worry about the nightmare of working every day for the rest of my life just to cover a tiny short position.


Without the institution of short selling, society is made worse off. The timing of people's incomes do not always coincide with their consumption plans, and a short sale is a great way to bridge the gap.

And if short selling is a vital tool for bridging the gap between our incomes and consumption plans, it is important that the various media we use for shorting are capable of facilitating this process. When the future costs of covering a given short are difficult to predict, people will shy away from shorting to fund their spending needs, and the benefits of trying to bridge the gap between income and consumption plans will go unexploited. Society is made worse off.

The best media for this purpose—those most capable of providing a predictable price—will become society's generally-accepted media for shorting. So maybe money isn't just a medium of exchange, store of value, and unit of account; it's also a popular short-selling medium. That's why we see stable instruments like Federal Reserve dollars or Bank of Tokyo-Mitsubishi yen deposits or Barclays pound deposits serving as the world's most prolifically-shorted media. Sure, bitcoin and Netflix short sellers certainly exist, but this is a very niche sort of transaction undertaken by highly-trained financial practitioners or fools. They aren't generally-accepted short media.


Bitcoin is a particularly awful medium for short selling because its lack of fundamental value leads to jaw-dropping volatility. Anyone who borrows one bitcoin (which currently trades at $19,000) and then sells it to finance a $19,000 purchase, say a car, could easily end up owing $190,000 two or three months down the road. That'd be a mere 10x price increase in the price of bitcoin, which is just a regular month or two in bitcoinland. A price move of this degree could easily bankrupt the car buyer.

Which in turn could bankrupt the person who lent to them. A bitcoin lender must account for the potentially lethal effect bitcoin's price spikes will have on his or her customer base by incorporating a premium into the interest rate charged to their customers. This means that the interest costs of borrowing and shorting $19,000 worth of bitcoin in order to buy a car will always be more than the costs of borrowing $19,000 worth of Federal Reserve banknotes. 

Because this volatility is inherent to bitcoin, it will always be bad at helping people build vital bridges between incomes and consumption plans. Don't expect it to ever become a generally-accepted medium for short selling.    


What other features make for a good generally-accepted medium for shorting? When it comes time to cover one's shorts by buying back Netflix or bitcoin, there may not be enough of these instruments available, which can lead to a huge spike in their price. These are called short squeezes.

Money is different. The supply of modern money is tiered, with the public at the top, commercial banks in between, and a central bank at the bottom layer. When a spike in the public's demand for money occurs (otherwise known as a bank run), private banks will try to accommodate that spike until they can't, at which point they can turn to the central bank for help. The central bank can in turn manufacture whatever quantity of new money is necessary to meet that demand. So short squeezes will always be prevented by the central bank. That's a feature that neither Netflix nor bitcoin can offer.


If the central banker's job is to maximize people's ability to bridge long gaps between income and spending by ensuring the predictability of the generally-accepted medium for shorting, might there be a better rule for managing things than inflation targeting?

Say that a recession hits and a large part of the population loses their jobs. If the central bank has an inflation target, those who have jobs can continue to easily cover the same quantity of dollars shorted by selling their labour whereas those without jobs will not be able to cover their shorts at all. Aggregating these two groups together, there is a net reduced capacity for short covering. So we might say that the central bank is failing at its job of providing a predictable medium for shorting.

If the central bank were to temporarily boost inflation to 4% when a negative shock occurs, it would be easier for the unemployed to cover their shorts than under a permanent 2% inflation targeting regime. For instance, with inflation at 4% rather than 2% an unemployed person would be able to sell their car or couch at a higher price than otherwise in order to cover a short position. For those on the flip side of the coin—those who make their living lending the medium for shorting—a temporary increase in inflation to 4% means their loans will be less valuable. But at the same time, the increase in the odds that the unemployed will be able to cover their shorts means that creditors needn't fret so much about the hazards of bankrupt customers.

So everyone wins. The converse could work too. When the economy is booming and jobs plentiful, the central bank could reduce inflation to 1% or so, thus making it slightly harder for people to cover their short positions. By using a rule that improves predictability in both regular times, downturns, and booms, the central bank provides a superior shorting medium for bridging gaps between incomes and consumption plans than under a flat inflation targeting regime. I suppose this is an argument for NGDP targeting over inflation targeting?