Tuesday, June 20, 2017

The road to sound digital money


No, I'm not talking about sound money in the sense of having a stable value. I'm talking about money that is sound because it can survive natural disasters, human error, terrorist attacks, and invasions.

Kermit Schoenholtz & Stephen Cecchetti, Tony Yates, and Michael Bordo & Andrew Levin (pdf) have all recently written about the idea of CBDC, or central bank digital currency, a new type of central bank-issued money for use by the public that may eventually displace banknotes and coin. Unlike private cryptocoins such as bitcoin, the value of CBDC would be fixed in nominal terms, so it would be very stable—much like a banknote.*

It's interesting to read how these macroeconomists envision the design of a potential CBDC. According to Schoenholtz & Cecchetti, central banks would provide "universal, unlimited access to deposit accounts." For Yates this means offering "existing digital account services to a wider group of entities." As for Levin and Bordo, they mention a similar format:
"Any individual, firm, or organization may hold funds electronically in a digital currency account at the central bank. This digital currency will be legal tender for all payment transactions, public and private. The central bank will process such payments by debiting the payer’s account and crediting the payee’s account; consequently, such payments can be practically instantaneous and costless as well as completely secure."
I don't want to pick on them too much, but all these authors are describing a particular implementation of central bank digital money: account-based digital money. There's an entirely different way to design a CBDC, as digital bearer tokens. My guess is that the authors omit this distinction because macroeconomists tend to abstract away from the differences between various types of money. Cash, coins, deposits, and cheques are all just a form of M in their equations. But if you get into the nitty gritty, bearer tokens and accounts two are very different beasts. Some thought needs to go into the relative merits and demerits of each implementation, especially if this new product is to replace banknotes at some hazy point in the future.

Let's first deal with account money. An owner of account-based money needs to establish a connection with the central issuer every time they want to make a payment. This connection allows vital information to flow, including instructions about how much money to transfer and to whom, confirmation that there is sufficient funds in the owner's account, and a password to confirm identity. Only then can the issuer dock the payor's account and credit the payee.

Bearer money, the best examples of which are banknotes and coins, never requires a connection between user and issuer. As I described in last week's post, courts have extended to banknotes the special status of having"currency." What this means is that if you are a shopkeeper, and someone uses stolen banknotes to buy something from you, even if the victim can prove the notes are stolen you do not have to give them back. The advantage of this is that there is never any need for a shopkeeper to call up the issuer in order to double check that the buyer is not a thief.** As for the issuer, say a central bank, they are not responsible for the debiting and crediting of banknote balances, effectively outsourcing this task to buyer and sellers who settle payments by moving banknotes from one person's hand to the other. The upshot of all this is that since users and issuers of bearer money don't need to exchange the sorts of information that are necessary for an account-based transaction to proceed, there is no need to ever link up.

This makes bearer money an incredibly robust form of money. If for any reason a connection can't be established between user and issuer, say because of a disaster or a malfunction, account-based money will be rendered useless. Examples of this include the recent two-day outage of Zimbabwe's account-based real-time gross settlement system due to excess usage, or the famous 2014 breakdown of the UK's CHAPS, its wholesale payments system, which limited the system to manual payments. M-Pesa, Kenya's mobile money service, has periodic outages, and last month my grocery store, Loblaw, suffered from a malfunction in its debit card system. Banknotes—which don't require constant communication with the mothership—worked fine throughout.

The private sector used to be heavily engaged in providing bearer money, both in the form of banknotes and bills of exchange. However, bills of exchange-as-money went extinct by the early 1900s. As for banknotes, the government thoroughly monopolized this activity by the mid-1900s. Which means the government has—perhaps inadvertently—taken on the mantle of being the sole issuer of stable, disaster-proof money. So any plan to slowly phase out government paper money is simultaneously a plan to phase out society's only truly robust payments option.

Going forward, it's always possible that governments once again allow the private sector to  issue bearer money. With the government's bearer money monopoly brought to an end, the public would be well-supplied with the stuff and central banks could safely exit the business of providing a robust payments option. But I can't see governments agreeing to relinquish this much control to private bankers. Which means that for society's sake, whatever digital replacement central banks choose to adopt in place of banknotes and coins should probably have bearer-like capabilities in order to replicate cash's robustness. Account-based money won't cut it. Nor will volatile private tokens like bitcoin.

One way to design a digital bearer money system is to have a central bank issue tokens onto a distributed ledger and peg their value, say like the Fedcoin idea. The task of verifying transactions and updating token balances would be outsourced to thousands of nodes located all over the world. So if all the nodes in the U.S. have been knocked out, there will still be nodes in Europe that can operate the payments system. This would restore a key feature of banknotes, that they have no central point of failure, thereby allowing central banks to get rid of cash. I'm sure there are other ways of creating robust money than using a distributed ledger, feel free to tell me about them in the comments section.



* CBDC would be redeemable on a 1:1 basis for traditional central bank money (and vice versa), so the two would have the same value and be interchangeable. Consumer prices, which are already expressed in terms of traditional central bank money, would now also be expressed in terms of CBDC. Since consumer prices tend to be sticky for around four months, CBDC holdings would have a long shelf-life. If CBDC was designed like bitcoin--i.e. its quantity was fixed and there was no peg to existing central bank money--then its value would diverge from traditional central bank money. Price would continue to be expressed in terms of traditional central bank money, and would be sticky, but there would be a distinct CBDC price that would no longer be sticky. So CBDC would no longer have a long-shelf life; indeed, CBDC prices could become quite volatile. See here.
** The caveat here is that while banknotes have long since been granted currency, CBDC—which does not exist—has not. Nor have cryptocurrencies like bitcoin been granted currency status. But if a central bank were to issue a bearer form of CBDC, it's hard to imagine the courts not declaring it to be currency fairly early on, unlike say bitcoin.

PS: I just stumbled on a 2006 paper from Charles Kahn and William Roberds which nicely captures these two types of money:


Saturday, June 17, 2017

On currency


David Birch recently grumbled about people's sloppy use of the term legal tender, and I agree with him. As Birch points out, what many of us don't realize is that shopkeepers have every right to refuse to accept legal tender such as coins and notes. This is because legal tender laws only apply to debts, not to day-to-day transactions. If someone has borrowed some money from you, for instance, then legal tender laws dictate a certain set of media that you cannot refuse to accept to settle that debt. These laws have been designed to protect your debtor from a situation in which you demand payment in a rare medium of exchange, say dinosaur bones, effectively driving them into bankruptcy.

Conversely, they also protect you the lender from being paid in an inconvenient settlement medium. In Canada, for instance, a five cent coin is legal tender, but only up to $5. If your debtor wants to pay off a $10,000 debt using a truckload of nickels, you can invoke legal tender laws and tell them to screw off—give me something more convenient.

Joining in with Birch in the grumbling, I'd argue that people make just as many errors with the term currency as they do with legal tender. When we use the word currency, we typically mean a grab bag of paper money, coins, deposits, and cryptocurrencies, or we use it to describe national units of account such as dollars, yen, pounds, pesos, ringgits, bitcoin, etc. But the word currency shouldn't be used so sloppily. 

Henry Dunning Macleod, a monetary theorist who wrote in the 1800s, has an interesting discussion of the etymology of the word. Macleod was a unique character in his own right. Trained as a commercial lawyer, he signed up as director of the Royal British Bank which failed in 1856 due to questionable loans and self dealing. Macleod went on to write a number of large tomes on monetary theory,  history, and law, including the Elements of Economic, on which I am drawing from for this post. Perhaps his main contribution to economics is the coining of the term Gresham's law, according to George Selgin.

From Macleod we learn that currency used to be used an adjective, not a noun. Certain types of goods or instruments were considered to be "current" in the eyes of the law and common business practice. They were said to have "currency," but were not themselves currency. Here is a clip from his book:
Let's break this down. Property that had been granted currency had a different legal status from property that didn't. Let's assume that a good has been stolen and sold by the thief to a third party, a shopkeeper, who innocently accepts it not knowing that it has been stolen. For most forms of property the original owner could sue the third party and get the stolen article back. But not if that good is one of the few to be considered by society to have currency, wrote Macleod. When an article is said to have currency, or to be current, the original owner cannot chase the third party to recover stolen property. So in our example, our shopkeeper gets to keep the stolen good, even if its stolen nature has been proven in court.

Coins had always been current according to mercantile practice, but if you read through Macleod you'll see that over the course of the 1700s, British common law jurists granted currency status to a series of new financial instruments, including banknotes, bills of exchange, stock certificates, exchequer bills, bonds, and more. (I went into this here.) What this illustrates is that an item didn't have to be money to have currency (e.g. bonds were considered to be current), nor did it have to be government-issued to be current (banknotes and bills of exchange were privately-issued).

Granting currency-status to a select group of instruments provided them with some useful mercantile properties. Consider first the converse: when the law did not grant currency to a certain good, any transfer of that good came with strings attached. For instance, if you tried to pawn off an expensive gold ring on a shopkeeper, the possession of that ring in your pocket would not be sufficient for the shopkeeper to establish title. If the ring had been stolen, and he/she accepted it, the shopkeeper might be forced to give it back to its original owner, leaving the shopkeeper out of pocket. So they would be wary at the outset about accepting the ring from you, perhaps requiring a time-consuming verification process before agreeing to the deal.

On the other hand, the shopkeeper would not hesitate to accept a gold coin. Because coins were current according to the law, anyone who received them in trade would not have had to worry about returning them to an angry victim down the line, and therefore could avoid the necessity of setting up a costly verification procedure. This would have encouraged trade in these instruments, rendering them much more liquid than items that weren't current.

According to Macleod, it was only after these early court cases that people started to directly refer to banknotes, coin, yen, dong, pounds, krona, and the like as currency-the-noun, a linguistic switch which Macleod angrily blamed on Yankee "barbarism":
"It is quite usual to say that such an opinion or such a report is Current: and we speak of the Currency of such an opinion or such a report... But who ever dreamt of calling the report or the opinion itself Currency?... To call Money itself Currency, because it is current, is as absurd as to call a wheel a rotation, because it rotates...Such as it is, however, this Yankeeim is far too firmly fixed in common use to be abolished."
It is interesting to note that while not all instruments that had currency were money (i.e. bonds), likewise not all money was granted currency status. According to Macleod, bank deposits did not have currency because, unlike banknotes and coins, deposits could not be dropped in the streets, stolen, lost or transferred to someone else by manual delivery. If you think about it, each movement of a bank deposit requires direct contact with the banking system in order to process the transfer. This effectively weeds out transfers of lost or stolen property, especially in Macleod's day where banking was conducted in person at a branch. Since anyone receiving bank deposits in payment needn't worry about a deposit being dubious, there was no need for the law to grant currency status to deposits.

All of this still has relevance today. Take the case of private cryptocurrencies, ICOs, and central bank digital currencies (CBDC). Because law makers have not been very clear about their legal status, bitcoin and other forms of crypto don't have currency, at least not in the Macleodian sense of the term. This means that a storekeeper who accepts bitcoin (or a future Fedcoin) may also be taking on the liability to give said coins back if they are proven to be stolen. And this lack of currency-status can only handicap a cyptocoin's ability to freely circulate.

If this post achieves anything, it's to illustrate that a special amnesty was once granted to a small set of financial instruments. This amnesty used to be referred to as currency. While we don't have to go back to the old practice of using of the word currency to refer to this special amnesty, we should at least be aware that this amnesty is still present and relevant.

Friday, June 9, 2017

The forking of the Indian rupee


This post is about the dismantling of the rupee-zone between 1947-49, an historical event that is especially topical in light of two modern monetary projects: Narendra Modi's poorly-executed 2016 demonetization and a potential eurozone breakup.

Thanks to a recommendation by Amol Agrawal, who blogs at the excellent Mostly Economics, I've been pecking away at the 900-page history of the Reserve Bank of India, although I have to confess that I've spent most of my time on the chapter on the partition period. For those who don't know, India and Pakistan weren't always independent countries. Up until partition in August 1947, each was part of British India, a British colony. The rupee, which was issued by the Reserve Bank of India (RBI), was the sole medium of exchange in British India. By mid-1949, less than two years after partition, usage of RBI-issued rupees had been successfully limited to the newly-created state of India. As for Pakistan, it had managed to erect its own central bank, the State Bank of Pakistan, as well as introduce a new currency, the Pakistani rupee.

At the time of partition, Pakistan's architects faced a daunting challenge; given that the Brits had announced in early 1947 that the partition of British India was to occur that August, there remained only a few months to create a central bank and issue a new currency. Because printing enough new currency for an entire nation would take far more than a few months to achieve, a temporary solution was arrived at: to use the RBI as an interim agent for issuing currency until the new Pakistani central bank had its own printing presses up and running.

This "bridge" involved using a combination of regular RBI-issued rupees circulating within Pakistan at the time and "overprinted" notes issued by the RBI. To ensure that the purchasing power of the two rupees stayed locked, the overprints were to be accepted by the RBI at par with regular notes. When enough Pakistani rupees had been printed by the newly-created State Bank of Pakistan, or the SBP, the mix of India rupees and overprinted notes was to be demonetized and replaced by Pakistani rupees on a 1:1 basis.

Here is what the Pakistani overprints looked like.


Note that they have the text "GOVERNMENT OF PAKISTAN" inscribed on them. Otherwise, overprints were just like regular rupees of the time.

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Let's pause and bring this to the present. Like the rupee breakup of 1947-49, Modi's recent demonetization involved the cancellation of a large proportion of existing currency followed by an issue of new banknotes to replace them. (The 500 and 1000 rupee notes represented some 85% of India's paper money.) This is where the similarities between the two projects end. The architects of partition were wise enough to realize that they did not have enough time to print sufficient quantities of Pakistani rupees to replace Indian rupees, and so to avoid burdening the public with a shortage of cash they decided to use existing RBI-issued currency as a bridging mechanism.

Modi and his team of monetary architects evidently did not bother to familiarize themselves with RBI history. If they had, not only would they have realized what a huge task it is to replace the majority of a nation's currency, but they would also have learnt some tricks—like overprinting—to make the project easier. (Overstamping, a technique similar to overprinting, was successfully used in the break-up of the Austro Hungarian krona in 1991 as well as the Czechoslovak koruna in 1993.) This refusal to draw on the RBI's institutional memory means that some eight months after demonetization, Indians are still suffering from cash shortages.

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Let's return back to the partition and explore the forking of the rupee more closely. The SBP, which was established July 1, 1948, formally took over the RBI-issued overprints as their liability that same day. As fresh Pakistan rupees came off the printing presses over the next months, SBP officials would steadily replace these overprints. That same day, the RBI subtracted the entire stock of overprinted notes from its total banknote liability. (The RBI had been issuing these notes since April.)

In taking over a large percent of the RBI's banknote liabilities, the SBP would need an equivalent set of assets to act as backing. These assets were to come from the RBI. More specifically, a fixed portion of the RBI's gold, coin, sterling-denominated securities, and rupee-denominated securities was to be transferred to the SBP, the rest remaining in India to serve a backing for RBI-issued rupee banknote.

To ensure fairness, a formula was settled on ahead of time to determine how the assets were to be apportioned. On a fixed date, the RBI would tally up how many notes were in circulation in Pakistan and how many in India, and divvy up the underlying assets according to the distribution of notes. That's fair way to do things, at least in theory. For the overprints, the RBI would record how many it had issued by July 1, 1948, and for each rupee overprint in existence it would transfer an equivalent quantity of assets to the SPB. When July 1 came, some 9.9% of the RBI's assets were dispatched to Pakistan. Thus one half of the mix of notes circulating in Pakistan, the overprints, had been demonetized.

There still remained the second half of the mix—regular Indian rupees. Dealing with these was more complicated. Unlike overprints, the RBI could have no firm measure for how many regular rupees were still being used in Pakistan, and thus had no way of knowing how many backing assets to transfer to the SBP. Intead, a mechanism for tallying up notes was established such that all Indian rupees circulating in Pakistan had to be brought to SBP offices for conversion into Pakistani rupees before July 1, 1949, one year after the central bank's founding. As Indian rupees flowed into the SBP over the course of the next twelve months, SBP officials remitted them to the RBI. The RBI then transferred an equivalent asset to the SBP for each Indian note it had received up until the expiry of the conversion period on July 1, 1949, after which the RBI ceased to accept remitted Indian rupees.

At this point, the RBI and the SBP were officially divorced. All liabilities and assets had been distributed to each respective party.

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In a potential breakup of the euro, a formula like the one devised by the RBI will have to be used. The results, however, are likely to be messy. Because as I'll show, the divvying up of the RBI's assets wasn't without controversy.

If you look at the SBP's 2016 financial statements, you'll see an interesting line item called "Assets Held With the Reserve Bank of India":

Source


Go to note 14, and you'll see that:
"These assets were allocated to the Government of Pakistan as its share of the assets of the Reserve Bank of India under the provisions of Pakistan (Monetary System and Reserve Bank) Order, 1947. The transfer of these assets to the Group is subject to final settlement between the Governments of Pakistan and India"

So it seem that Pakistan never received what it believes to be its fair portion of the RBI's assets. For almost 70-years now it has carried these IOUs on its balance sheet (see historical date here). That's a long time to hold an asset that is unlikely to be collected! The reason for this odd balance sheet item can be found on page 568 or the aforementioned 900-page RBI tome. Between the founding of the SBP in July 1948 and the July 1949 cutoff date for note remittances to the RBI, more Indian rupees had filtered over the border into Pakistan than expected. As such, Pakistan was able to stake a larger claim on the RBI's assets than initially estimated.

Indian officials, who were not happy with the amount of assets they were sending over to Pakistan, now claimed that only those notes already in circulation in Pakistan as of July 1948 could legitimately be remitted for underlying assets. Any notes that were imported into Pakistan from India after that date simply would not count to the final tally. Pakistani disagreed. In March 1949 the Indian government informed the bank that "pending negotiations with the Pakistan Government further releases to them should be withheld." This was unfortunate news for the SBP. It had effectively issued Pakistani rupees without a reciprocating asset to back them.* That's where the two parties stand to this day—the SBP grudgingly holds the RBI's IOU on its books as reminder that it never got its perceived fair share of the RBI's assets.
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This sort of havoc is inevitable when a monetary union breaks up. If existing notes are to be converted into new national notes at a one-to-one basis over a fixed period of time, then everyone has an incentive to export their notes to the region that is expected to have the strongest national currency. I am speculating here, but in September 1949—just three months after the RBI had been successfully divided—India devalued its rupee by 30.5%. Pakistan didn't. So all thoe holding Pakistani rupees were suddenly 30.5% richer than those holding rupees. Maybe the mass banknote exodus into Pakistan during the conversion period was an attempt to avoid this impending devaluation.

This same sort of dynamic would surely characterize a euro break-up. If Europeans are given 6-months to convert their euros into new national currencies like the German mark or the Greek drachma, you can bet that everyone will ship their euros to Germany. Drachmas, like the Indian rupee, are sure to be devalued. And if the final distribution of banknotes is to serve as the marker for divvying up the European Central Bank's assets, then Germany would get most of them. Were it to be prevented from getting its share, then Germany would end up in the same situation as Pakistan, with a shortage of good assets to back up all the fresh marks it has issued.

*If you're interested in specific amounts owed, here's an old World Bank document on the issue.

Tuesday, May 30, 2017

Evaluating my bitcoin predictions


I wrote a bunch of posts on bitcoin between 2012-2015, but they tailed off a bit in late 2015 and 2016 as my attention turned to other subjects, namely old fashioned banknotes and cash, a terrifically fertile topic. Because my bitcoin posts tended to get a lot of comments at the time, I thought it would be worthwhile to go back and review some of the predictions I made, both for my sake and that of my readers.

My predictions tend to fall into three related buckets.
  1. Bitcoins will not become a generally-accepted medium of exchange
  2. Even mainstream organizations like the Fed might one day want to adopt bitcoin tech
  3. Bitcoin will fall to zero
On the first front, I've consistently written that bitcoin won't become a generally-accepted medium of exchange because of its volatility. And this prediction has panned out, so far at least. No, bitcoin has not destroyed VISA, nor has it driven the share prices of remittance providers like Western Union to zero, nor has it been adopted by unbanked Africans and Bangladeshis.

From a more anecdotal perspective, I live in what I like to think is a fairly vibrant part of Montreal filled with early adopters, but I never see shops or cafes that accept bitcoin. None of my circle of friends and family have ever tried the stuff, and when they ask me about it, it's always to gossip about the crazy high prices—not bitcoin-as-a-medium-of-exchange. Let's face it, bitcoin and other cryptocoins are great speculative vehicles, but they're flops as money.

On the second front, I've written about how the distributed ledger aspect of bitcoin could be split off from the token itself and used by financial institutions See here, for instance. This is the rough idea behind the "blockchain" movement that started up in 2015 or so. We'll see if it pans out. I also predicted that central banks would adopt bitcoin technology before banning it, perhaps in the form of a distributed currency, and have since wrote multiple posts on the Fedcoin idea. No central bank has quite got there yet, but they've all started talking about digital currency and have even been experimenting with it. So I think I've done alright on these predictions.

It's boring being right because you don't learn anything. My last prediction, that bitcoin will hit zero, is my most interesting one because I got it so wrong. In 2012, I wrote:
"My hunch is that bitcoin still has a positive value because proper competition will take a few years to truly develop. Let's see where we are in December 2013."
By December 2013, bitcoin had hit $800, not $0. Similarly, this:
"There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1."
Or this from 2014:
"If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world."
To further illustrate how bad I got this one,I once owned 24 bitcoins. I bought them back in the fall of 2012 for around C$12 each (~US$10) for a total outlay of C$290. Thinking I was a genius, I sold out the next year when the price hit C$100, earning what thought to be a nice 700% return. Had I ignored my prediction and held, given today's bitcoin price of ~CAD$3000 my small stash would be worth a cool C$72,000. Ouch. That's not fun to read.

Given this incredibly wide miss, it's high time to re-evaluate my reasoning for a zero price of bitcoin. Do I turtle-in and keep my prediction or do I update it?

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Here's how I've been thinking about the problem.

There are two types of assets in this world. Type A assets can only provide a return to their current holder if a stream of subsequent investors, buyers, or participants are recruited to provide that return. Examples include Ponzi schemes, chain letters, and pyramid schemes. Type B assets, on the other hand, can provide a return to their owner, even if no subsequent person ever steps forward to acquire that asset. Good examples of Type B assets are gold, land, stocks, and central bank-issued banknotes.

Say a buyer's strike suddenly hits the market for a Type B asset. Everyone decides to sell at the same moment so that the asset is offered at $0. An arbitrage opportunity presents itself. Since this asset will either yield a dividend (in the case of a stock), have some usage in decorating (like gold), or is destined to be repurchased by its issuer at some positive price (think central banks withdrawing banknotes by selling assets), anyone who buys it for $0 is getting something for nothing. As people compete to feast on this free lunch, prices will re-ratchet back up until the opportunity has disappeared. For this reason, Type B assets are characterized by price floors and buyers strikes are not crippling.

No equivalent arbitrage opportunity presents itself when a buyer's strike hits a Type A asset. Say Bernie Madoff issues a bunch of tickets, each providing its holder with a spot in a Ponzi scheme. A few days later, no one wants to purchase Madoff's tickets. Sure, you can now buy a ticket for $0, but because they have no intrinsic value the only way you'll be able to come out ahead is by selling it for more to another buyer, say for $1. This will require that you (or someone else) incur expenses on marketing the scheme i.e converting already angry sellers into buyers. This sounds like an awful lot of work, certainly too much to merit paying anything more than $0. Probably better to start an entirely new Type A asset than try to reboot the failed one. The upshot is that because Type A assets lack an arbitrage mechanism and marketing is costly, buyer's strikes quickly bring the game to an end. There is no floor.

Bitcoin is a Type A asset. It is unconsciously so, there being no Madoff-like evil genius at the centre of the scheme. It just sort of emerged spontaneously.

Like other Type A assets, bitcoin lacks a price floor. When a bitcoin buyer's strike hits, and bids across all the bitcoin exchanges evaporate, a bitcoin held in your wallet is worthless. There is no underlying business that can throw off dividends nor a central issuer that can cancel unwanted tokens. Sure, you can always purchase a bitcoin for $0, but in order to come out ahead you'll have to convince someone to buy it for $10. This means you'll have to regenerate the hype, excitement, and belief that initially spawned a positive bitcoin price. If you're not willing to spend time and money on these efforts, you better hope someone like Andreas Antonopoulos will. Whatever the case, any effort to push bitcoin back into positive territory will be costly.

Given that buyer's strikes are the death knell for Type A assets, it is vital to recruit a constant stream of new buyers to the cause. In bitcoin's case, recruitment has been easy. No Ponzi scheme ever boasted as engaging a mythology as bitcoin, starring the dashing and mysterious Satoshi Nakamoto, a radically decentralized digital currency poised to destroy the existing financial system, and "in math we trust". Because these ideas are so catchy, the mythology has pretty much sold itself—an incredibly cost-effective way of recruiting new participants. Every time bitcoin has experienced a lull in buying and its price has plunged, it has never quite fallen to zero. A batch of new converts, inspired by the latest Andreas Antonopoulos video on YouTube, has always emerged from the woodwork.

While the mythology is strong, it has long since spread into the easy cracks, i.e. libertarians and tech geeks. New target demographics, many of which do not agree with the core philosophy underlying the mythology, won't be so easily convinced to add their bids to the queue. As for Satoshi Nakamoto, he/she is almost ten years old now and getting stale. And one of the core promises of the mythology, the birth of a generally-accepted digital currency, has fallen flat. People are getting jaded.

Luckily, Bitcoin has always had a far more seductive recruiting tool, a rapidly rising price. While the technology and philosophy underlying bitcoin might motivate a few geeks, a 50% price jump is a universal intoxicant. Past returns bring the promise of future returns, waves of new buyers pushing the stuff ever higher. However, this process faces limits. The bigger bitcoin gets, the larger the stream of recruits needed to drive the price higher. At some point its market capitalization will get so large that the population of buyers necessary to keep the ball rolling will be exhausted. And when bitcoin can no longer demonstrate that it offers a superior return, a buyer's strike will hit as everyone rushes to sell at the same time, it's price falling to zero.  

So in the end, even though I've been terribly wrong I'm going to stick to my guns on this one. If I'm going to recant my bitcoin-to-zero views, you're going to have to convince me that a Type A asset can last indefinitely. I don't see how. Empirically, we know that Type A assets are precarious, short-lived things. There are no Ponzi or pyramid schemes still running from the 1800s, or the 1920s, or even from 2001. Bernie Madoff's Ponzi scheme, which popped in 2008, may have been the longest running Type A asset ever, it's alleged start date being the early 1970s. That's over thirty years. (Public run pension schemes don't count, since the government can coerce participation). If there is a reason that bitcoin can escape this fate, please explain in the comments section—maybe I'll see the light.

Monday, May 8, 2017

Three-tier pricing


Americans and Canadians take for granted that fact that while a multiplicity of dollar brands circulates in our respective nations, a dollar is always equal to a dollar. In the U.S.'s case, whether it be a VISA card, paper money issued by the Federal Reserve, or a deposit created by a either a big bank like Wells Fargo or a tiny one like Wisconsin Bank & Trust, a retailer will (almost always) accept each of these monies at the same rate.

Compare this to Zimbabwe where a phenomenon called three-tier pricing has emerged over the last few months. Retailers have begun to charge customers three different prices for goods and services depending on the brand of dollar being used: a paper U.S. dollar price, another in "plastic money" (i.e. local U.S. dollar-denominated bank deposits transferable by debit card), and the last price in terms of relatively new parallel paper money called bond notes.

To better illustrate three-tier pricing, here is a photo of a Zimbabwean store sign:


You can see that the list of goods being sold is denominated in U.S. dollars, bond notes, and "swipe" i.e. plastic money. Under three-tier pricing, those who pay with U.S. dollars get the lowest price while anyone who pays with plastic money faces the highest price. For instance, the item labelled Kingsize (cigarettes maybe?) retails for $9 in U.S. banknotes, $9.50 in bond notes, and $10 in plastic money. Given these rates, the shop estimates that a US$100 bill is worth $105 in bond notes and $111.11 in deposits.

These rates are generous. There are reports (see here, here, and here but there are many more examples) that bond notes and plastic money often trade at discounts as deep as 20-30% to U.S. dollars.

Three-tier pricing may seem odd, but it is actually the market's natural response to a breakdown in the fungibility, or substitutability, of various types of money. While plastic money and U.S. paper money used to be perfect substitutes (i.e. they traded at par) from 2009-2015, over the last twelve months the quality of plastic money has rapidly deteriorated relative to U.S. paper dollars as it has become increasingly apparent that a bank deposit is a claim on the Zimbabwe government rather than on an actual U.S. dollar. Needless to say an IOU issued by the Zimbabwe government is not a very good claim to own.

As for bond notes, a paper dollar look-alike originally issued by the central bank at the end of November 2016, they were supposed to be pegged 1:1 by equivalent U.S. dollars held in accounts at an international development bank, the African Export Import Bank. But this promise has proven to be a dubious one as the peg has not held. In this context, three-tier pricing is a way to recognize the  fundamental breakdown in fungibility by rewarding users of the highest quality medium, U.S. banknotes, with the most advantageous price, and penalizing users of the lower quality mediums--bond notes and plastic money--with less advantageous prices. (To see why bond notes are worth more than plastic money, see the appendix below).

This panoply of prices is quite embarrassing to President Robert Mugabe and his cronies as it makes the government look weak. They are trying to put an end to three-tier pricing by forcing retailers to set one universal price for goods. To this effect, recently-passed legislation says:
Retailers and wholesalers shall sell any particular product for the same price irrespective of the mode of payment and desist from multiple pricing of goods on account of mode of payment (cash, Real Times Gross Settlement (RTGS) and Point of Sale or a combination of any two or more of them).

For the avoidance of doubt, retailers and wholesalers shall not charge any premium for the sale and purchase of their wares on the basis of mode of payment. Similarly any cash or quantity discount shall, in accordance with best practice, be granted in the normal course of business and not on the basis of the multiple pricing system.
The penalty for not accepting cash and plastic money at par is up to seven years in jail.

By forcing retailers to accept all brands of money in Zimbabwe at par, Mugabe is interfering with the market's natural response to a breakdown in the relative quality of different monies. His actions will inevitably set off a specific set of responses dictated long ago by Gresham's law: if the government specifies the exchange rate at which money must be accepted by the populace, then the good, or undervalued money will be chased out by the bad, or overvalued money.

We know from its relative position in the three-tier pricing mechanism that plastic money is Zimbabwe's worst money. By requiring retailers to accept the two paper monies--U.S. dollars and bond notes--at par with the inferior money, plastic, Mugabe is forcing retailers to dramatically undervalue paper currency. As per Gresham's law, Zimbabwean shoppers who own U.S. dollars and bond notes will prefer to hoard and/or export them rather than spend them at artificially undervalued rates, using only plastic money to buy things. Thus the bad chases out the good. Media reports concur with this prognosis. U.S. paper money, which had already started to disappear back in November when bond notes were declared legal tender, is all but impossible to find. And now bond notes are getting more elusive too.

To try and fix the very problem it has created, the Reserve Bank of Zimbabwe--the nation's central bank--has initiated a whistle-blowing campaign against cash hoarders. Good luck with that; cash is very easy to hide. If the authorities really want to end cash hoarding, they should re-legalize three-tier pricing. With the market sorting mechanism reestablished, the true value of cash will once again be recognized and banknotes will flow back into the market. Of course, these prices will only bring back the premium on U.S. dollars, making it terribly obvious to all how poorly the government's credit is esteemed by the market. Unfortunately, this is exactly why three tier pricing is unlikely to be legalized. This situation won't have a happy ending.




Appendix

I had been meaning to include the following bits in the main body, but on second thought decided to put them into an appendix. What follows is a quick history of how each of the three tiers has developed.

First Tier

As readers will probably remember, a hyperinflation of the local currency finally ended with the populace spontaneously adopting the U.S. dollar in 2008. Deposits denominated in the local currency became worthless with banks only offering U.S. dollar deposits to their customers. Since then, Zimbabwean prices have been mostly been in set in terms of dollars.*

Second Tier

In 2016 a two-tier system emerged when U.S. banknotes and "plastic money" ceased being fungible (bond notes had not yet been created). The nation's central bank--the Reserve Bank of Zimbabwe (RBZ)--reopened for business sometime after the nation had dollarized. It began to offer U.S. dollar accounts, or IOUs, to local banks for the purposes of settling interbank payments, later forcing them to keep a certain amount of money on deposit at the RBZ. In theory, these IOUs were supposed to be fully backed and convertible into genuine U.S. dollars, a promise that has proven to be a tenuous one as the RBZ has been rationing access to U.S. dollars since early 2016.

This has left local banks in the lurch. Stuck with a bundle of more-or-less inconvertible RBZ IOUs, they now lack the resources to meet their depositors' U.S. dollar redemption requests. As a result, a nationwide bank run developed in early 2016 which led to the imposition of strict withdrawal limits. Ever since then, long queues at ATMs have been a perpetual phenomenon as bank customers, desperate for cash, wait--often overnight--to withdraw their quota of U.S. banknotes.**

With redemption now impeded, U.S. dollar deposits had effectively been decoupled from U.S. cash. By mid-2016 a black market of sorts had developed in which cash, the superior money, now traded at a premium to deposits, or plastic money. To cope with this lack of fungibility, retailers came up with an ingenious workaround; they began to set a cash price and a "plastic money" price, the cash price being lower.

Any retailer that did not set a lower price for U.S. dollars would not be able to "lure" U.S. dollars out of customers' pockets with the proper market reward. And without U.S. dollars, it would be difficult to import products from overseas to sell to customers.  An alternative strategy to two-tiered pricing is to simply require U.S. dollars only, like here:



Source

But this single-tier pricing strategy inconveniences customers with bank accounts and may attract the disapproval of authorities.

Third Tier

The third tier emerged when the RBZ introduced its own parallel issue of U.S. dollar banknotes, called bond notes, at the end of November 2016. This parallel currency currently comes in $1, $2, and $5 denominations, although the RBZ had earlier promised to introduce higher denominations.

In its initial announcement, the government had promised that bond notes would be fully backed and redeemable in genuine U.S. dollars provided by an international development bank, the African Export Import Bank. But this redemption promise is not being kept [source]. Those who want to redeem bond notes for U.S. banknotes have found that they face the same hurdles as those who want to redeem deposits. Thus, just as deposits have been decoupled from U.S dollars and fallen to a discount, so have bond notes.

Although deposits and bond notes are both inferior imitations of the U.S. dollar they do not themselves trade at par with each other, bond notes being valued at a premium to plastic money. My guess is that this has to do with the fact that, till now at least, the supply of bond notes has been kept to ~$120 million, with the government reportedly unwilling to issue more. [source] Given the fact that many Zimbabweans do not have bank accounts and only transact with paper, the limited amount of bond notes that has been created is insufficient to meet the nation's demand for cash. So there is a scarcity premium built into the price of bond notes.

* Some prices were also set in rand, the South African currency
** The other way of emptying one's bank account, wiring dollars overseas, has likewise been constricted as foreign exchange is tightly rationed by the central bank.

Tuesday, April 25, 2017

Leaving a monetary union is difficult, but Hawaii pulled it off


In campaigning for a departure from the Euro, both France's Marine Le Pen and Italy's Beppe Grillo,  make the process sound easy. But one does not simply walk out of a monetary union. There are all sorts of messy problems to deal with, including harmful bank runs, massive banknote shortages, and long legal battles with investors over wealth confiscation and the redenomination of debts.

I recently stumbled on a successful and rarely-discussed exit from a monetary union: Hawaii in 1942. Hawaii's was a different sort of exit than a potential French or Italian euro exit. Whereas the latter are reactions to being straitjacketed in the face of a slow and grinding recovery from financial crisis, Hawaii's exit was executed in anticipation of a potential military invasion. Despite differing motivations, it's worth investigating the Hawaiian episode to see what it takes to pull off a successful exit.

To understand the course of events, I drew on several Fed bulletins from 1942 (including this one),  but for the most part relied on Martial Law in Hawaii, written by Brigadier General Thomas H. Green, the man who designed Hawaii's exit from the U.S. monetary union (PDF here). As everyone knows, Pearl Harbor was bombed by the Japanese on December 7, 1941. Hawaiian residents soon began to fear that a full scale invasion was imminent, and a bank run of sorts developed on the island. Here is Green describing the run:
"From the time of the Blitz, everyone realized the possibility of the return of the Japs and naturally gave consideration to the safety of their money. Those who had bank deposits began to worry about the security of their deposits and as a result many withdrew their savings and secreted them in various places considered safe...The result was that the banks were gradually running out of cash."

In the light of what the Japanese invasion forces were doing in the Pacific theatre, fleeing one's bank made good sense. According to Green, when the Japanese surprised the British forces in Singapore, they confiscated all hard currency, both from banks and and individuals' wallets. For the recalcitrant, Japanese troops had "special procedures" for getting prisoners to give up their possessions. Later on, the territories occupied by the Japanese would be forced onto a scrip-based monetary standard which quickly succumbed to inflation. Given such a fate, better for Hawaiians to withdraw U.S. banknotes ahead of an anticipated Japanese invasion rather than during or after one. That way they'd have enough time to find a good hiding spot for their notes on Hawaii, or ship them to the mainland for safekeeping.

The same sort of defensive run that occurred in Hawaii also happened several years ago in Greece. Greek fears that they would be cut off from the euro, their deposits suddenly frozen only to be redenominated into a much less valuable unit of account, led them to cash out before the anticipated event. In both cases, premonitions of confiscation motivated the run.

Brigadier General Green put an end to Hawaii's bank run on January 9, 1942 by prohibiting the withdrawal of more than $200 per month from banks and forbidding anyone from holding more than $200 in cash. Although he doesn't specify, I'm going to assume that this $200 limit applied not only to cash withdrawals but also bank wires from Hawaii to mainland banks. By putting an end to the convertibility of local bank deposits, Hawaii now had one foot out of the dollar zone. A dollar held in a Hawaiian bank was no longer quite like a dollar in the rest of the U.S.

For those with long memories, the same thing happened in Greece in 2015 when capital controls and cash withdrawal limits were imposed. Frozen Greek euros held in banks were no longer fungible with the rest of Europe's money. 

In principle it should be very difficult to enforce limits on cash holdings. Yet Brigadier General Green described the effect of his prohibition as "astonishing." Where before banks only had $1.5 million on deposit, over the next several days long lines developed to deposit funds so that after the order, banks found themselves with more than $20 million on deposit. Much of the banknotes were "moist and even wet," noted Green, indicating that they had been recently unearthed from hidden caches. 

While Green's prohibition stopped Hawaii's bank run, it didn't solve the problem of how to prevent notes from being seized should the Japanese invade. Green's initial solution to the confiscation problem was clumsy one. On the first sign of an invasion, Treasury employees toting burlap bags were to run to important intersections in Honolulu where they would collect bundles of banknotes from citizens, providing a receipt in return. The burlap bags containing the money would then be delivered to the city incinerator where they would be burned. The receipts, which would be redeemable for currency after the war, would be worthless to the Japanese, who wouldn't be able to collect on them.

Luckily, Green soon came up with a more elegant approach: create a new currency, or scrip, ahead of time. In the event of an invasion, this scrip would be immediately outlawed by a simple proclamation, thus preventing its use by the Japanese. Far easier to solve the confiscation problem by mere proclamation than have employees standing at intersections with burlap bags. Agreeing to the idea, the U.S. Treasury had a special issue of banknotes printed up. The new bills were similar to ordinary U.S. banknotes except that the seals and the numbers were printed in brown ink instead of green and the bills bore the word "Hawaii" overprinted in black on both sides (see top image).

On July 7, 1942 the Governor announced that anyone in Hawaii holding U.S. currency had until July 15 to visit a bank and turn the notes in for special Hawaii overprints. After the 15th, it would be illegal to hold regular banknotes. Henceforth, all notes imported from the mainland had to be immediately turned over to the authorities for conversion. Exports of overprints was prohibited. Anyone who wanted to transfer wealth to the mainland had to exchange it with authorities for regular currency. The punishment for evading these rules was harsh:
"Whoever is found guilty of violating any of the provisions of such regulations, shall, upon conviction be fined not more than five thousand dollars ($5,000), or, if a natural person, may be imprisoned for not more than five (5) years, or both." (source)

Over the 7-day exchange window, U.S. banknotes that were brought into banks for conversion were collected and burned. According to the New York Times, more than $200 million was taken to a crematorium in Oahu that soon ran out of capacity, the rest subsequently being hauled to furnaces at a a local sugar mill. Among the officer ranks, the task of serving on the crew that burnt notes was much sought after. Here is Green:
"Applications for the last named post were numerous and it was not until I learned of the practice of lighting cigarettes from bills of large denominations that I understood the desirability of such duty. This ritual was enjoyed, especially by young officers who had little prospect of handling, much less burning, bills of large denominations."
So by July 15, 1942, Hawaii had effectively left the dollar zone. Gone were regular greenbacks. The sole media of exchange were Hawaiian overprints and overprint-denominated deposits. In practice, the authorities maintained a policy of pegging Hawaiian dollars to U.S. dollars at a rate of 1:1. But if they wanted, they could have easily ratcheted that peg down or up. Alternatively, in the event of an invasion, the authorities could completely unpeg the Hawaiian dollar and let its exchange rate float. Without a strong central bank to back it, the exchange rate would probably have plunged to zero, or at least close to it. Which was exactly the point of Green's scheme... to take all the difficult steps of leaving the U.S. monetary union ahead of time so that, come an invasion, only the last (and easiest) step remained, floating the currency. Very clever.

The era of the Hawaiian dollar was a short one. With the Japanese threat now much diminished, Hawaii would be reabsorbed into the dollar zone in 1944. Regular U.S. dollars were once again allowed to circulate in Hawaii while the issuance of overprints was halted. In 1946 all overprints were recalled and destroyed.

---

Could Le Pen or Grillo follow the Hawaii scrip script (pardon the pun) and leave the eurozone by declaring capital controls and then printing out new paper money? Greece went half way when capital controls were instituted in 2015... could it not have gone all the way?

There were probably a few factors working in Major General Green's favor that Le Pen and Grillo lack. To begin with, Hawaii is an isolated set of islands. Avoiding the note exchange window and sneaking dollars to the mainland would have been tricky. European borders are quite porous. I don't see why French or Italian citizens would submit to bringing their euro banknotes in for conversion to an inferior currency  when they could easily sneak them across the border into Germany.

Second, martial law had been imposed in Hawaii whereas Italy and France are democratic nations at peace. It would be much harder for the likes of Le Pen and Grillo to pass the draconian set of laws (and associated punishments) necessary for exit.

In executing an exit from a monetary union, in the time that elapses between the limit on bank withdrawals and the issuance of a new currency, the economy will probably suffer from a deep note shortage. Because so many people remaining on Hawaii were enlisted men whose needs were taken care of by the army, monetary exchange was less crucial. Not so the economies of modern France and Italy, which would endure a crippling shortage of transactions media.

Finally, the attitudes of citizens are different in wartime. United against a common enemy and trusting of their leaders, Hawaiian residents by-and-large submitted to the monetary inconveniences that were seen as necessary to winning. Witness the long lines described by Green for depositing notes after the $200 holding limit was established in January 1942, despite the impossibility of authorities actually enforcing such a rule. Le Pen and Grillo, on the other hand, govern divided populations. The requisite society-wide eagerness to leave the euro, one that would emerge in the face of a strong invading force, just isn't there.

Sunday, April 9, 2017

C-day and military money


 Did Indian PM Narendra Modi get the idea for the recently-executed demonetization by watching old episodes of M*A*S*H, a 1970s hit TV show set in the Korean War?

In the clip below, M*A*S*H's Colonel Potter is alerted to an imminent phasing out old "blue" military money with red, the idea behind the switch to punish counterfeiters and black marketers. As the conversion is happening, Colonel Potter is ordered to make sure that the gates to the base are closed so as to prevent illegitimate blue money from being smuggled in for changing. Sounds a bit like Modi's November 8, 2016 sudden phasing out of ₹1000 and ₹500 notes, no?



The money switch depicted in the M*A*S*H episode isn't just fiction. During the Vietnam War, mass demonetizations were a fairly common event on military bases. To isolate dollar-using U.S. troops and civilian contractors from the regular Vietnamese monetary system, U.S. military authorities fashioned a parallel scrip-based system in which Military Payment Certificates, or MPCs, displaced regular dollars as the medium of exchange on U.S. bases (see top for an example).

All troops arriving in Vietnam were required to convert their U.S. cash into MPCs at a 1:1 rate. Over the course of a tour, troops received a monthly MPC stipend which could be spent at the army store on things like cigarettes or Pentax cameras. Usage of certificates by local Vietnamese or by troops off-base was prohibited. At the end of their tour, troops would reconvert all MPCs back in to dollars at the 1:1 rate, since any MPCs brought back to the U.S. were useless.

Unsurprisingly, the rule prohibiting non-American usage of MPCs was ignored as Vietnamese retailers began accepting MPCs from American GIs in payment. This sort of dollarization was seen as a bad thing by the U.S. military and Vietnamese government. Any spread of dollars into the domestic economy would displace local currency (in Vietnam's case the piastre), hindering the goal of rebuilding the local economy. The spread of dollarization was exactly what the scrip system had been designed to prevent. U.S. authorities would periodically carry out sudden cancellations of existing MPC, replacing them with a new issue of scrip so as to strand Vietnamese users. With all Americans being confined to base on conversion day , or "C-day", there was no way for locals to get U.S. soldiers to act as go-betweens for conversion. This ever-present threat of C-day should, in theory at least, slow down the dollarization of the Vietnamese economy.

The other reason for regularly cancelling and reissuing MPCs was to flush out U.S. troops engaged in black market activity.  All GIs were allowed to convert a fixed amount of old MPC on C-day, no questions asked. Unusually large conversion requests above that amount would be investigated by military police to ensure that this wealth hadn't been dubiously acquired. To avoid being investigated, a would-be black marketeer might choose to sacrifice their MPCs, thus losing a large amount of wealth. These periodic losses would drive up the costs, and attractiveness, of engaging in black market activity.

The success of these conversions depended on secrecy, since any leakage of an imminent C-day would cause unauthorized users of MPC to quickly convert their hoard into goods at the military store, or exchange them on the black market into piastre or regular dollars. According to Prugh, the first C-day on October 21, 1968 resulted in $276.9 million in certificates being converted, with $6.2 million going unaccounted for, presumably because they were in the hands of unauthorized persons. The next C-day occurred less than a year later, on August 11, 1969. In the next conversion on October 7, 1970, about 25% of recalled MPCs were not accounted for, according to this GAO document. The final C-day took place almost three years later on March 15, 1973.

There were all sorts of ways to game the scrip system. During their tour of duty, troops were allowed to exchange MPC into dollars and transfer that value home by money order, as long as this amount did not exceed the soldier's monthly stipend. To get around these limits, those holding excessive amounts of MPC could recruit others with spare sending capacity as 'straw men' to transfer money on their behalf. We saw this happening in India too. During the recent demonetization, each Indian was allowed to deposit ₹250,000 worth of demonetized notes during the 50-day conversion period, no questions asked. Those holding large amounts of rupees paid others under the table to make use of their shelter.

Another trick used by GIs was to have regular $100 bills mailed to Vietnam. A GI could sell these dollars to a local for MPC at a premium, says $110. Locals were willing to pay this premium because regular dollars, which couldn't be demonetized, offered them protection . The GI could then convert this $110 in MPC into $110 dollars upon departure (or by money order), thus earning $10 round-trip.

Modi's reasons for embarking on demonetization mirrors those of the Vietnam-era C-day. The U.S. military used conversions to encourage use of piastre among locals; Modi used it to encourage use of digital money. And both want to attack the black market. It is somewhat worrying, however, that the best historical analogue for Modi's demonetization comes from wartime. I do realize that the army has developed a number of technologies now in wide civilian use, including the internet, but as a general rule the mechanisms adopted to cope during wartime are probably not ideal for peacetime.

The MPC program died decades ago. Nowadays, regular cash circulates freely on U.S. army bases overseas. Interestingly, the military is making an effort to go cashless, due in part to the high cost of shipping banknotes and coin to distant war theaters. To help cut these costs, the Department of Defence used cardboard tokens, or "pogs", rather than metal coins in the recent wars in Iraq and Afghanistan.
The Department of Defence has also encouraged usage of the EagleCash card, a stored-value card. One thing is for sure: closed-loop digital money is a far more effective way than paper-based scrip for isolating an army from the domestic monetary system of the nation it is occupying.

Sunday, March 26, 2017

Bringing back the Somali shilling


Somalia has long played host to one of the world's strangest monetary phenomenon, a paper currency without a central bank. I explored the idea of Somalia's "orphaned currency" more fully four years ago, but if you're in a rush what follows is the tl;dr version. Despite the fact that both the Central Bank of Somalia and the national government ceased to exist when a civil war broke out in 1991, Somali shilling banknotes continued to be used as money by Somalis. Over the years, Somalis also accepted a steady stream of counterfeits that circulated in concert with the old official currency, a state of affairs that William Luther explores in some detail here.

The story is worth revisiting because apparently Somalia's newly restored central bank is on the verge of re-entering the game of printing banknotes after a quarter century absence. With the help of the IMF, the Central Bank of Somalia (CBS) plans to issue new 1000 shilling banknotes, the introduction of higher denomination notes coming later down the road.

Old legitimate 1000 shilling notes and newer counterfeit 1000 notes are worth about 4 U.S. cents each. Both types of shillings are fungible—or, put differently, they are accepted interchangeably in trade, despite the fact that it is easy to tell fakes apart from genuine notes. This is an odd thing for non-Somalis to get our heads around since for most of us, an obvious counterfeit is pretty much worthless. The exchange rate between dollars and Somali shillings is a floating one that is determined by the cost of printing new fake 1000 notes. For instance, if a would-be counterfeiter can find a currency printer, say in Switzerland, that will produce a decent knock off and ship it to Somalia for 2.5 U.S. cents each (which includes the cost of paper and ink), then notes will flood into Somalia until their purchasing power falls from 4 to 2.5 U.S. cents... at which point counterfeiting is no longer profitable and the price level stabilizes.

Below is the long-term price of Somali shillings, which I've snipped from Luther's paper. You can see how the purchasing power of a 1000 shilling note has fallen to what Luther calculates to be the cost of producing a new banknote, around 4 cents. His chart goes up to 2013, but if you look at the IMF's most recent report on Somalia (see Figure 3) you'll see that the exchange rate hasn't moved much.

From Luther

So with a new official banknotes on the way, what will happen to the old legacy notes and counterfeits? According to the IMF mission chief Mohammed Elhage, the IMF is in the midst of trying to determine at what price it will convert old notes for new official ones. So rather than repudiating counterfeits, the normal route taken by central bankers, the CBS will buy them up and cancel them. It will have to offer a decent price too, say like 5 or 6 U.S. cents for each 1000 note. If it makes a stink bid, say 3 U.S. cents, Somalis may simply ignore the appeal to bring in their old currency and keep using the old stuff. Because the buyback decision validates the work of counterfeiters, it just seems wrong. However, keep in mind that for the last twenty-five years it has been counterfeiters who have been willing to take on the risk of providing Somalis with a very real service, the provision of a working paper medium of exchange.

There is another good reason for buying up old legacy notes and counterfeits and cancelling them. If the CBS lets the old notes stay in circulation, then Somalia's ragtag multi-currency system will only get more confusing, with old legacy and counterfeit notes circulating concurrently with new shillings and U.S. dollars. With the new issue of shillings having a different purchasing power than the old ones, yet another floating exchange rate will be added to the mix. Who needs that sort of confusion? Better for the CBS to absorb the cost of buying up fakes in order to promote a more homogeneous currency.

***


As I pointed out in my old post, there's an old and nagging question in monetary economics that has never been satisfactorily answered: why is fiat money valuable? Somalia serves as a great laboratory to investigate this question because its situation is so unique. One famous answer to the riddle of fiat money is that governments use force to ensure that fiat money is valued. But this can't be the case in Somalia: it hasn't had a government since 1991, yet shillings continue to be accepted.

A second answer is that once money is valued—say because it a central bank has been pegged to an existing store of value like gold—then once the central bank disappears and the anchor is lost, those orphaned notes will continue to have value by dint of pure inertia and custom. This theory certainly seems to fit Somalia's experience.

The last theory is that when a central bank is destroyed, the money it issues will quickly become worthless... unless citizens expect a future central bank to emerge and reclaim the orphaned currency as its own. If so, it makes sense to keep using the currency since it isn't actually orphaned—it's on the way to being adopted. If the expectation is that this future central bank will also adopt counterfeit notes, it makes sense for people to accept all knock-offs as well. So we can tell a story that shillings, both real and fake, never fell to zero because enough Somalis had a hunch that a future body would reclaim them, a hunch that is on the verge of being realized as a newly-christened CBS seems set to buy old and fake shillings back. Were Somalis really this good at predicting the future? I don't know, but like the second theory, the last one seems to explain the data.
 
***

Personally, I think introducing a new paper currency is a bad idea. For some time now Somalia has been partially dollarized economy. U.S. dollar banknotes are the most popular paper currency, with old shillings being used in small payments and in the countryside. Mobile payments are extremely popular, but they are usually denominated in U.S. dollars, not shillings, and tend to be prevalent in cities where network coverage is best.

There are several problems with dual-currency systems like Somalia's. First, they impose a small but steady stream of currency conversion costs on the population, both the actual cost of shifting one's wealth from one to the other as well as the mental gymnastics involved in converting prices in one's head. Secondly, there are fairness issues. Civil servants are usually paid in the domestic currency and those in rural parts deal in the stuff. Urban private sector workers tend to earn dollars. In developing nations, dollars are usually more stable than domestic currency. As a result prices of houses, cars, and rent are often set in dollars. The class of folks who are paid in dollars make out better than the class that is earning shillings. Dollar earners never have to leave the much stabler dollar loop while those earning domestic currency suffer from constant slippage due to conversion costs and chronic inflation.

Now the IMF might argue that new shillings will completely expel dollars, thus forcing everyone into the same shilling loop and removing any monetary inequalities. But that's hog wash. The literature on dollarization teaches us that once the dollar begins to be used by a country—usually because the domestic currency has suffered from high inflation—it is very hard to remove it. Long after the local currency has been successfully stabilized, dollarization continues, an effect referred to by economists as hysteresis. Bring back the shilling and the dollar will stick around.

While bringing back new shillings doesn't make much sense, some sort of currency reform is probably worthwhile. While cities seem to be already well-served by dollars and mobile money, the rural population still relies on old and deteriorating shilling notes. Instead of foisting new shillings on these people, why not replace them with locally-minted small denomination dollar coins? I call this the Panama solution. For those who don't know, Panama is a dollarized nation. Due to the high costs of shipping in coins form the U.S., Panama mints its own dollar-denominated small change, paper money printed by the Federal Reserve taking care of the rest of the nation's physical money requirements. 

By adopting the Panama model all Somalis would get to deal in U.S. dollars, thus removing any monetary class divisions. Gone too would be the headache of constantly converting between shillings and dollars, since with U.S. coinage there would only be dollars. And poor Somalians living in rural areas without phone coverage would finally get clean and homogenous small denomination cash.

Admittedly, there's far less for a central banker to do if he/she issues a narrow range of small denomination U.S. denominated coins, say 1¢, 5¢, and 25¢, rather than a full range of banknotes. It's certainly not sexy. But it would be cost effective. Coins, after all, last much longer than notes. This durability means that coins are a cheaper circulating medium for a central bank to maintain than paper. There is also the national ego that must be satisfied. What nation doesn't have its own currency? The worst reason to adopt a new shilling is because some concept of nationhood requires it—Panama has been using the dollar for decades, and this hasn't prevented it from becoming one of Central America's most successful nations.

Wednesday, March 15, 2017

The dematerialization of cash

"One dollar bill," watercolour by Adam Lister (source)

R3, a company specializing in distributed ledger technology, has just posted a paper I wrote for them entitled Fedcoin: A Central Bank-issued Cryptocurrency. And here is a nice write-up on the Fedcoin idea in American Banker, which unfortunately is behind their paywall.

The paper is pretty wide-ranging, but one thing that's worth focusing on is the ability of Fedcoin to provide some of the same features as banknotes, in particular anonymity and censorship resistance. That a Fedcoin system can be designed to provide the same degree of privacy as cash runs counter to some of its early critics, who see in Fedcoin a coming financial panopticon.

One really neat things about good ol' cash is that, like bitcoin, it is a decentralized network. The opposite of this is a centralized network, say something like the deposit banking system. In the banking system, storage of value is handled by the issuing bank through accounts hosted on the bank's database. Conversely, in a banknote system, the issuing central bank offloads the task of storing value onto us. We the public—think of us as nodes in a decentralized network—are responsible for choosing how and where to keep our cash, say in a wallet, or under our bed, or in a safety deposit box, as well as bearing those storage costs. The central bank doesn't care how we manage this task, though they'd prefer that we don't mangle the notes too much.

Or take the process of securely transferring value. Centralized actors like banks handle all the stages of moving deposits from a buyer to a seller, including verifying identities, ensuring adequate account balances, updating ledger entries etc. But in a transfer of banknotes, the transaction process is entirely devolved to the buyer and seller, who must physically move the cash to the right location, count out by hand the necessary quantity of banknotes, and then come to a consensus that the transaction has been settled. As for the central bank's ledger of notes, there is nothing that needs updating. Unlike private bankers, central bankers don't care who owns their circulating liabilities.

The task of screening for counterfeit notes is also outsourced to the public. Each time a shopper accepts a banknote, say as change, they'll give it a once-over to verify that it hasn't been run off by a teenager using an inkjet printer. Retailers deal in cash all day and are familiar with banknote anti-counterfeiting devices, and thus can exercise more judgement in checking for fakes. And banks, the recipient of notes from retailers at the end of the day, will catch many of the counterfeits that have slipped through the system.

Banknote systems aren't entirely decentralized, of course. The central bank has the final say on whether a note is counterfeit or not. It also regulates the purchasing power of those banknotes, either by toggling interest rates higher or lower, repurchasing money using its portfolio of assets, or issuing more money in return for assets.

Because they are at least partly decentralized, banknote systems inherit two nice features: anonymity and censorship resistance. The first feature is self-explanatory: the central issuer makes no effort to determine the identity of a banknote owner. Proceeding from this, the issuer lacks enough information to censor, or prevent any particular party, from using the banknote network. These are completely open systems. By contrast, centralized systems like banks can easily censor members of the public from making payments. Take the Huntingdon Live Sciences episode in 2001, for instance, in which a UK-based company involved in drug-testing was cut off by British banks in response to pressure from animal rights activists. Other examples of censorship by banks include the blockade of Wikileaks and the monetary embargo of Iran.

Now in theory a banknote system could be modified by introducing more centralization, thus removing anonymity and introducing censorship. Each banknote has a unique serial number. The central bank could set a rule that for every cash transaction, the buyer and seller are obligated to log in to a government-provided account where they register the note's serial number into a tracking database. To get these accounts, users would be required to submit documents and ID. This would destroy the anonymity of cash users and open the door for censorship. In practice, though, the guardians of banknote systems have chosen to preserve anonymity by ignoring serial numbers.

One of the major trends over the last decades has been dematerialization, the replacement of paper by bits and bytes as a medium for holding data. This saves on costs like printing, storage, and distribution; improves speed; and reduces waste. We saw it with stock & bond certificates a few decades ago, books, newspapers, music, record keeping, bills. And one day we may see it with cash. The question is: how to allow for the dematerialization of cash without losing its useful features like anonymity and censorship resistance?.

Bitcoin is one answer. But Bitcoin only goes half-way to solving the problem since it does not recreate one of cash's other key features, its stability. A nation's prices are conveniently denominated in terms of its paper money (i.e. U.S. retailers set prices in dollars, Japanese retailers in yen), and since prices tend to stay sticky for 4.3 months or so on average, the public has a huge degree of certainty over the medium-term purchasing power of the money in their wallets. This is a very nice feature. Bitcoin prices? Not so stable.

Fedcoin may be able to recreate this stability while still providing anonymity and censorship resistance. A government copies the source code of a proven cryptocoin (maybe bitcoin, maybe zcash, maybe ethereum), boots the system up, and promises to peg the price of each coin to its existing banknotes, say 1 coin = $1 banknote.

As with bitcoins, anyone would be able to hold Fedcoins without the necessity of providing identification. And like Bitcoin, Fedcoin could be designed in such a way that a distributed collection of Fedcoin nodes (or miners) validate transactions by referring to the system's shared history. Remember how the Fed allows banknote users to anonymously come to a consensus about the validity of a banknote transactions i.e. they do not have to log in to an account to register note serial numbers? Likewise, Fedcoin could be designed in a way that nodes have the ability to remain anonymous. This would preserve a degree of censorship resistance and openness. After all, if validators must unveil themselves, governments and other powerful actors might compel those nodes to censor transactions.

This is just one way of setting up anonymous central bank money. I'm sure there are many others. There are also ways to set up non-anonymous central bank money, but these are less interesting to me, a point I made here. As I point out in the R3 paper, I think my preferred set-up would be to allow individuals a rationed amount of anonymity, targeting some sort of “sweet spot” such that there is enough anonymity-providing exchange media for regular consumers but not enough for criminals. But I can't wrap my head around how to design something like this. Anyways, go read the paper, there's plenty more.



PS: I also recently had an article on bitcoin published in the Common Reader, a publication of Washington University in St. Louis.

And since we're on the theme, I should link to some other public appearances by yours truly, including recent-ish podcasts with David Beckworth and Alex Millar.

Wednesday, March 8, 2017

Why the American taxpayer might prefer a large Fed balance sheet


David Andolfatto and Larry White have been having an interesting debate on the public finance case for having a large (or small) Federal Reserve balance sheet. In this post I'll make the case that American taxpayers are better off having a large Fed balance sheet, perhaps not as big as it is now, but certainly larger than in 2008.

To explain why, we're going to have to go into more detail on some central banky stuff.

The chart below illustrates the growth of the Fed's balance sheet. Prior to the 2008 credit crisis, the Fed owned around $900 billion worth of assets (green line), these being funded on the liability side by $800 billion worth of banknotes (red line), a slender $10-15 billion layer of reserves (blue line), and a hodgepodge of other liabilities. The Fed now owns an impressive $4.5 trillion in assets. These are funded by around $1.5 trillion worth of banknotes and $2.3 trillion worth of reserves. So the lion's share of the increase in the Fed's assets is linked to the expansion in reserves, which have ballooned by around 25,000%.


There's a problem with the above chart. It shows reserves clocking in at just $10 billion prior to 2008, but it's important to keep in mind that this *understates* the quantity of reserves issued by the Fed. Prior to 2008, the Fed would typically lend out tens of billions worth of reserves to banks during the course of the day, these amounts being paid back before evening. These loans are referred to as "daylight overdrafts." Because the above chart uses end-of-day data, it omits daylight overdrafts, thus making the balance sheet look smaller than it actually was.

How big did the Fed's balance sheet actually get during the course of a day thanks to overdrafts? Prior to the 2008 credit crisis, daylight overdrafts typically peaked at around $150 billion. So if we recreate the chart using intraday Fed data, the pre-2008 balance sheet would be around $800 billion + $150 billion, or 20% larger than if we use end-of-day data. And rather than a relatively flat pattern, we see a pulsing pattern. I've drawn out the chart by hand to give a sense for how the balance sheet would have looked, although its not to scale and doesn't use real data.



So why does the Fed offer daylight overdrafts? One of the business lines in which a commercial bank participates is the processing of payments on behalf of its clients to other banks, these recipient banks in turn crediting sent funds to their clients. To make these interbank payments, banks use deposit accounts at the central bank, or reserves.

In the U.S., legally-stipulated reserve requirements force banks to hold small quantities of central bank reserves overnight. So when the U.S. banking system opens in the morning for business, a bank will typically already have some funds in their reserve accounts that can be used to make client payments. However, the ability of this small layer of required reserves to carry out the nation's payments will soon be swamped—after all, the quantity of transactions conducted on a single day using reserves is massive, currently clocking in at $3 trillion.

In theory, banks might choose to hold an excess quantity of reserves overnight (i.e. more than the legally mandated minimum) in preparation for the next day's payment cycle. However, the Fed has historically kept the overnight interest rate on reserves at 0%, far below the market overnight interest rate. So no bank wants to hold reserve overnight if they can avoid it. If they did, their profits would suffer.

To ensure that banks have the ability to carry out the nation's business come morning, the Fed has typically provided the necessary reserves via daylight overdrafts. When the banks close for business in the evening, the Fed then sucks the reserves it has lent to banks back in. Alex Tabarrok once fittingly described banks as inhaling credit during the day, "puffing up like a bullfrog" —only to exhale at night.

As I mentioned earlier, before the credit crisis hit Fed-granted daylight overdrafts used to rise as high as $150 billion over the course of the day. Since 2008, the quantity of daylight overdrafts has declined quite dramatically. See the chart below:

source

Why have banks stopped applying for overdrafts? In 2008 the Fed began to pay interest to any bank that held reserves overnight. Rather than "exhaling at night," it suddenly made sense for banks to hold reserves till the next morning. This new demand for overnight balances was not met by daylight overdrafts, which must be paid back by the end of the day. Rather, a new permanent supply of reserves began to emerge thanks to the Fed's policy of quantitative easing. Under QE, the Fed created reserves and spent them to purchase bonds, these reserves staying outstanding as long as the Fed did not repurchase them, potentially for decades. The upshot is that banks are now quite happy to hold huge amounts of Fed-issued reserves on a permanent basis. As such, they no longer need to make use of daylight overdrafts to carry out the nation's payments. 

So let's bring the conversation back to the taxpayer. As you should hopefully see by now, the debate between keeping a big balance sheet and returning to its pre-2008 size is closely intertwined with the following question: do we want our central bank to provide daylight overdrafts or not? Because if we are to go back to 2008—i.e. to a period when overnight reserves were "scarce," as Larry White describes it—then by definition we are advocating daylight overdrafts.  

I'd argue that taxpayers might prefer that the Fed not provide daylight overdrafts. To begin with there is the question of credit risk. If a bank that has been granted an overdraft were to fail during the course of business, the Fed would be out of pocket. Since the central bank is ultimately owned by the taxpayer, that means taxpayers could take a big hit when a bank fails.

The Fed could protect itself by requiring banks provide collateral as security for access to Fed overdrafts. Now when the offending bank goes under, the Fed has a compensatory asset in its possession that it can use to make good on the loan, thus sparing the taxpayer. However, the protection afforded the Fed by collateralized daylight overdrafts comes at the expense of the nation's deposit insurance scheme, the Federal Deposit Insurance Corporation, or FDIC. To ensure that depositors of a failed bank are made whole, FDIC typically sells off the bank's assets. If the Fed has taken one of those assets for itself as collateral for a daylight overdraft, FDIC will have one less bank asset at its disposal and may have to dip into taxpayer funds to make up the difference. The overall risk faced by the taxpayer has not been reduced.

By maintaining the status quo—i.e. a large quantity of reserves—the taxpayer gets more protection from bank failures. Banks must buy reserves, or tokens, ahead of time to ensure that they can meet the payments needs of their clients. So the Fed acts as a seller, not a creditor, and therefore does not expose taxpayers to risk of bank failures. At the same time, FDIC does not face the prospect of having risk shifted onto it should the Fed seize collateral from a failed bank with unpaid daylight overdrafts.

Now the preceding discussion might seem to tilt me towards David Andolfatto's position of keeping a large balance sheet, albeit for different reasons than him. Not entirely. While a large quantity of reserves will be sufficient to insulate the taxpayer from bank failures, it needn't be as large as the current $2.5 trillion in outstanding reserves. As I pointed out earlier, prior to the 2008 credit crisis the Fed would typically grant around $150 billion in daylight overdrafts. This was sufficient to facilitate ~$2.7 trillion in payments (see data here). So each dollar in reserves was able to support 18x that value in payments. The Fed currently processes around $3.1 trillion in payments, a task that could probably be discharged with ~$200 billion in daylight overdrafts, assuming that the 18x ratio still prevails. So as long as the Fed were to keep at least $200 billion of the $2.5 trillion in reserves outstanding, that amount should be sufficient to replace the need for daylight overdrafts.




Sources:

1. How the High Level of Reserves Benefits the Payment System and Settlement Liquidity and Monetary Policy Implementation, both by Bech, Martin, and McAndrews
2. Divorcing Money from Monetary Policy by Keister, McAndrews and Martin
3. Turnover in Fedwire Funds Has Dropped Considerably since the Crisis, but It’s Okay by Garratt, McAndrews, and Martin