Friday, July 21, 2017

Dictionary money

Nick Rowe points out that if a central bank wants to control the economy's price level, it needn't issue any actual money—it can just edit the dictionary every morning, announcing the meaning of the word "dollar" or "yen" or "pound" to the public.

To a modern ear trained on a steady diet of central bank verbiage about interest rates, QE, and open market operations, the idea of conducting monetary policy by simply editing the meaning of a word seems odd. But I've got news for you: starting from Caesar's time and extending into the 1700s, the sort of dictionary money that Nick describes has been the dominant form of money in the West.

How has this system worked? People have historically advertised prices for wares using a word, or unit of account, the LSD unit being the most prevalent. In the case of Britain this meant pound/shilling/pence while in France it was livre/sous/denier, both of which come from the Latin librae/solidi/denarii. The monarch was responsible for declaring what these words meant. More specifically, the king or queen would post a sign in some central area saying something to the effect that a pound, or £, was worth, say, ten testoons, a type of silver coin. This definition was subject to change. The next day, for instance, an edict might be issued saying that a £ was now only worth nine testoons. Or, put differently, the £ now contained less silver. Just like that, prices had to rise 10% to account for the alteration made to the dictionary meaning of the word "pound."

Dictionary systems came to an end when the symbol for money was finally fused directly with the instrument itself. Remember, coins never used to have denominations, or units of account, on their face. Rather, they usually only had the monarch's head inscribed on them, maybe the name of the mint, and a few words about how awesome the monarch was. This lack of numbering was convenient. Since coins had no association with the unit of account, the quantity of coins (and thus silver) in the unit of account (i.e. the definition of the word) could be seamlessly changed by royal proclamation.

In the 1700s monarchs began to adopt the practice of inscribing the actual unit of account directly on the coin's face, i.e. coins began to be etched with 5¢ or £0.5.* Once this happened it became awkward to change the definition of the unit of account by editing the dictionary. Having permanently stamped the meaning of the word "dollar" or "pound" on millions of widely-circulating bits of stamped silver, changing that meaning by simply posting a sign on a popular street corner no longer did the trick. Every coin would have to be recalled and re-minted too!

Having long since put the definition of the word "dollar" or "yen" onto the actual instruments they issue, modern monetary authorities now have to do something to the instruments themselves if they want to conduct monetary policy. Maybe they issue a few more units of money or buy them back in order to alter their purchasing power. Maybe they jiggle the interest rate that those tokens throw off. Or they might raise or lower a currency's peg. Some sort of tangible action (or threat thereof) must be taken to change the economy-wide price level. Word updates won't do.

About the only place in the world that has dictionary money is Chile which, buffeted by high inflation, adopted a parallel unit of account called the Unidad de Fomento (UF) in the 1960s. (For more on the UF, see my old post here). Today, Chileans can choose to set prices in UF or in the Chilean peso. The latter is a conventional money, the word "peso" being defined as the 1 peso banknote issued by the nation's central bank. Unlike the peso, the UF lacks an underlying UF banknote. Rather, the Chilean government defines the word "Unidad de Fomento" to mean the number of Chilean pesos required to buy a fixed Chilean consumption basket. This definition changes every day and is posted here.

I think this is a pretty neat idea. As long as Chileans denominate their salary and other contracts using UFs rather than pesos, they are guaranteed to earn a steady stream of consumption, even if the Chilean peso hyperinflates.

These days inflation isn't really such a big deal, at least not in developed nations—central bankers seem to have mastered how to keep the purchasing power of the medium of exchange from getting out of hand. So adopting something like the UF might seem redundant. A dictionary money system is also unattractive because it imposes a calculational burden on citizens. People must be constantly doing conversions between an item's sticker price and whatever happens to be the medium of exchange necessary to complete the transaction. So if a book were to be priced at $5, you'd have to consult a government website to determine how many bitcoins, or dollar bills, or silver coins would be necessary to constitute a five dollar payment. The advantage of our current system is that because the word and the medium are unified, we don't have to do these conversions. A five dollar bill always suffices to cover a $5 sticker price. Simple.

On the other hand, dictionary money may have a role to play in our relatively recent deflationary age. Beginning with Japan back in the late 1990s, central bankers all over the world have been incapable of preventing deflation, or falling prices. Are their tools inadequate? Do they refuse to use these tools to their full extent? Do they not understand how to use them? With dictionary money, a central banker can't blame his or her tools for a miss, since all it takes to alter the price level is an update to the definition. A child could do it.

For instance, a nation like Japan could create dictionary money by removing the word "yen" on bills. It would do so by recalling all outstanding banknotes and replacing them with, say, Japanese pesos. Prices, however, would continue to be set in terms of the yen unit of account. Each morning the Bank of Japan would announce to the world how many Japanese pesos were in a yen. Say it starts with the yen being defined as ten pesos. To create some inflation, it would simply proclaim that the yen now contained just five pesos. Everyone with pesos in their pocket would suddenly be able to buy twice as much yen-denominated products as before. They would race out and spend. Shopkeepers who had previously been selling widgets for 1 yen, and getting ten Japanese pesos as payment, would quickly jack up prices to 2 yen in order to ensure that they still earn ten pesos per widget.

Voila, instant inflation.

* See Ernst Weber's "Pre-industrial Bimetallism: The Index Coin Hypothesis " [link]

Wednesday, July 12, 2017

Money in an economy without banks

by Alex Schaefer
Most of the world's money is currently in the form of deposits created by banks. After the 2008 credit crisis, which instilled a strong suspicion of banks among the public, it became fashionable to ask what money would look like in an economy without these organizations. Burn them to the ground or shutter them, what would take their place? One vision is to pursue pure centralization: have the state monopolize all money creation, say by providing universally-available accounts at the nation's central bank. Positive Money is an example of this. Another alternative, by way of Satoshi Nakamoto, is to pursue radical decentralization: replace bank IOUs with digital commodity money in the form of bitcoin and other private cryptocoins.

I'm going to provide a few historical examples that sketch out a third option for replacing banks; bills of exchange. A system underpinned by bills of exchange is capable of converting illiquid personal IOUs into money using a distributed method of credit verification, as opposed to a centralized method patched through a banking organization. Unlike bitcoin, however, these are IOUs, not mere bits of digital ledger-space. While few people these days are familiar with the bill of exchange, in its hey day this instrument was responsible for executing a large chunk of the Western world's transactions. 


The first story is of cheques, an instrument that while not precisely a bill of exchange gets pretty close. Last week in my homage to the cheque I brought up the Irish bank strike of 1970, described by Antoin Murphy (from whom I steal the title of this blog post). When the nation's banks shuttered their windows for half the year, Irish citizens re-purposed uncleared cheques as personal IOUs, these cheques circulating as a cash substitute. The system was decentralized in that banking institutions no longer served as creators of the medium for making payments; instead, everyone became their own unique money issuer. As Tim Harford recently wrote, pubs and corner shops were able to vouch for the creditworthiness (or not) of each cheque.

Irish cheque money only circulated for six months. After the banks reopened in November 1970, mounds of cheques were cleared & settled and the system returned to normal. Luckily, we have historical examples that lasted much longer than this.


Let's go back in time to Antwerp in the late 1400s. The institution of banking had been present in Europe for a few centuries, but according to Meir Kohn (who I get much of this material from) it began to go into decline at the end of the 15th century as waves of bank failures broke out across the continent, due in part to coin shortages. In Antwerp, the authorities went so far as to ban the practice of banking in 1489. In lieu of bank deposits, coins could of course be used to make payments, but this would have been a step backward since deposit banking had emerged, in part, to solve the problems related to coins, specifically the fact that they are expensive to store, awkward to transport, and heterogeneous, some coins containing more precious metals than others.

Similar to the Irish five hundred years later, Antwerp's financiers adapted to the death of bank money by innovating a decentralized alternative. Where the Irish chose cheques as their payments instrument, Antwerp settled on a related paper-based order called the bill of exchange. A bill of exchange was a popular way to remit money in medieval times. Say you were a citizen of Florence and you needed to get 20 gold coins to a relative in Venice. Rather than incur the cost and danger of transporting the coins yourself, you might try and strike a deal with a merchant who had offices—and gold—in both cities. By paying the merchant some gold in Florence, your home city, he would issue you a bill of exchange. This bill ordered his colleague in Venice to pay out 20 gold coins to whoever happened to be the bill bearer. You'd then send the bill to your relative in Venice, and he'd bring it into the office and collect the money. The merchant would earn a commission on the deal. No actual gold would travel between the two cities, just a secure and light paper instrument. It was a fantastic technology for saving on the costs of shipping and handling heavy coins.

While bills of exchange started out as remittance instruments, they were later used by merchants as a form of credit. A merchant might want to sell some wool to a manufacturer who in turn required three months to convert the wool into cloth and sell it. To finance the purchase of wool, the manufacturer could always turn to a banker. Absent a banker, the merchant himself might provide the manufacturer with a loan by drawing up a bill of exchange. On its face this bill contained written instructions ordering the manufacturer to pay x coins three months hence to the bearer of the bill. The merchant would keep it in his desk, and when the requisite amount of time had passed he would bring the bill to the manufacturer and collect on his debt, earning interest in the meantime.

The common denominator of a bill of exchange, whether used as a remittance or as credit, is that a private citizen has issued their own personal IOU, to be redeemed for cash after some time has passed. Then Antwerp happened.

In its original form, a bill of exchange could only be used by a small group of people, the initial drawer of the bill, the payor, and the payee. Antwerp's financiers took the bill of exchange and converted it into a fully transferable instrument, or money. They pried open the closed circuit so that if merchant A owned a bill of exchange that was to be paid out in coin by merchant B next month, merchant A could in the meantime transfer this IOU to merchant C as payment, and merchant C could transfer it to merchant D, and D to E etc. These transfers, or assignments, could occur without asking the original debtor, merchant B, for permission. This would have dramatically increased the liquidity of bills of exchange, allowing them to fill the vacuum left in Antwerp by the banning of bank deposits,

To further protect anyone who received a bill of exchange in payment, Kohn tells us that these instruments were granted currency status by Antwerp's merchants. As I wrote here, this meant that even if the bill of exchange had been stolen from merchant B and paid to merchant C (who had innocently accepted it), merchant B could not sue merchant C to get the bill back. This legal upgrade would have further promoted the liquidity of bills of exchange, since merchants needn't bother setting up burdensome verification processes to ensure that bills of exchange presented to them were not stolen. In the eyes of merchant law, all bills of exchange were considered "clean."

There was still one last barrier to creating a truly decentralized medium of exchange; how to overcome stranger danger. Say that you and I are acquaintances and I owe you $20. I tell you I'm going to settle my debt by giving you an IOU issued by another party. Banks are a great way to solve the stranger problem, since everyone will agree to settle debts using the IOUs of a well-known and trusted intermediary like a bank. But say instead I offer you a $20 bill of exchange that I've received from a friend. If you know that person you'll probably accept the deal, but in an economy like Antwerp's with thousands and thousands of actors, you might not know the name of the debtor written on the bill. And without enough knowledge to accept the credit, you'd have probably refused it.

According to Kohn, the final innovation developed in Antwerp solved the stranger problem—the ability to endorse a bill of exchange. I simply signed my name to the back of $20 bill of exchange, or endorsed it, and handed it to you. By signing it, I was agreeing to accept the debt as my own. So if the original debtor failed to pay you for the bill when it came due, you could flip the bill over and pursue the first name on the list of endorsees—me—for payment. And since you knew and trusted me, it was now possible for you to evaluate the credibility of a $20 bill of exchange that had originally been issued by a stranger. Bills could in turn be re-endorsed on by others, a long chain of transactions being made before the bill finally expired. Indeed, Henry Dunning Macleod once remarked that bills might sometimes have "150 indorsements on them before they became due."

From Antwerp, the practice of using negotiable bill of exchange would spread to the rest of Europe, in particular Britain. Below is an example of a bill of exchange from 1815 that ordered Pickford's, an English canal company, to pay £72  11s 1d to Richard Vann. You can see first hand how the stranger problem is solved. The bill has multiple endorsements on its reverse side (pictured below), including that of Richard Vann, William Alcock, T S Marriott, William Whittles, Jones & Mann, Thomas Whalley & Sons, James Mitchell and Richard Williams. To see the front side of the bill, click through to the original link:


Not only did this chain of cosigning individuals solve the stranger problem. It also created an incredibly safe instrument. Bills of exchange were effectively secured not only by the original person whose name was inscribed on the front, Vann, but by all the others who had cosigned the back; Alcock, Marriott, Whittles, etc. The odds of everyone on the list failing would have been quite low. It was an ingenious system.


Another interesting anecdote on bills of exchange comes from the county of Lancashire in north west England in the 1800s. By then, banknotes had long since been invented and were a popular payments medium in England. Typically issued by small private "country banks," banknotes were a centralized payments technology insofar as their value depended on the good credit of one issuer, the bank. Inhabitants of Lancashire were particularly suspicious of these instruments which explains why there were almost no note-issuing banks in the county. T.S. Ashton speculates that this wariness was due to the 1788 failure of Blackburn-based Livesay, Hargreaves and Co, a banknote issuer: "generations after, when proposals were made for local notes, men's minds turned back to the events of 1788."

In the absence of a system of banks providing transferable deposits or notes, bill of exchange circulated in Lancashire, even dominated, so much so that they were often "covered with endorsements" and become famous for their dirty appearance. Indeed as late as the 1820s, Ashton tells us that some "nine-tenths of the business of Manchester was done in bills, and only one-tenth in gold or Bank of England paper." Bills were used even in small denominations, say to pay piece workers. This is surprising because bills of exchange had typically been used by merchants and wholesalers, and therefore tended to be issued in large denominations.

Alas, according to Ashton the Lancashire bill of exchange was done in by the increase in stamp duties, which effectively made it more cost-effective to use bank-issued forms of payment that didn't require a stamp.


Just a few random thoughts in closing.

While Ireland, Lancashire, and Antwerp all provide a sketch of an alternative, distributed form of converting personal IOUs into money, do we really need a replacement for banks? While the U.S. banking system certainly had its difficulties in 2008, Canadian banks skated smoothly through the crisis. Maybe banks only need a face lift.

Even if we need to burn the suckers down, a paper-based backup like bills of exchange or cheque just won't cut it—we need digital money. But is it possible to digitally replicate the features of a bill of exchange? And even if an online bills of exchange system could be built, we live in an age where money transmitting is a highly regulated industry—how legal would it be for individuals to take over the role of money creator, transmitter, and verifier? (I once thought that Ripple was the answer to digitally replicating bills of exchange. But they decided to serve banks instead. Maybe Trustlines fits the *ahem* bill?)   

Tuesday, June 27, 2017

An homage to the cheque (or check)

The check used to buy Alaska (source)

I recently read an FP article about the odd persistence of the cheque as a way to make payments. According to the author, even though cheques are slow and cumbersome, people are willing to live with these drawbacks because they like the ability to write messages in the memo field. Competing electronic payments options (in Canada at least) don't have the ability to write memos.  

As someone pointed out to me on Twitter, in the U.S. the cheque's memo field is more than just a place for writing personal reminders. According to the law in certain states, when you disagree with your creditor about how much is owed—say the contractor who is building your deck has spent too much on materials—by writing out a cheque for less than the agreed amount and including "paid in full" in the memo line, the debt is extinguished the moment the contractor cashes it.  

What follows are some other neat things about cheques that don't get much attention.

People tend to think of cheques as a mere set of instructions issued to a banker on how to move bank deposits. To transfer deposits, we could always just walk into a bank and do this in person, but we prefer to save time and energy by issuing the instructions on paper.

But a cheque is more than just a substitute for a set of in-person verbal instruction. By inscribing these instructions onto a long-lived medium, we've created an entirely distinct financial instrument, something akin to a debt or a derivative. As long as a cheque exists, it derives its value from the underlying deposits that are expected to be delivered by the issuer.

Normally we take for granted that a $1000 cheque is worth $1000. But this isn't always the case. For instance, if the cheque writer decides to spend a $1000 cheque that has been post-dated for three months—i.e. the underlying cash can not be collected till then—the receiver will typically only accept said cheque at a discount to face value, say $960. After all, the receiver needs to be compensated for the interest they will have to forego in holding that cheque for the three months to encashment, not to mention incurring the risk that the cheque writer fails in the interim.

We don't normally think of cheques as a form of debt or financing, but after India's demonetization an interesting example of this practice was brought to light. This fascinating story describes how small-scale enterprises in Varinasi accept post-dated cheques as payment and then bring them to a battawala—or "one who deducts"—for discounting. The battawala sets his commission, or discount, based on the creditworthiness of the cheque issuer. The ability to sell post-dated cheques allows these businesses to finance expense such as salaries and inventories. A second article describes a battawala market that "opens from 3-7 p.m. every day at Chowk, the heart of the business district," where several thousand battawallas sit and trade post-dated bearer cheques for cash.

North America also has a post-dated cheque market of sorts. Payday lenders, which offer short-term lending to those who can't get it from banks, only issue loans on the provision of a post-dated cheque. They accept these cheques at large discount to face, so that a $350 cheque can only buy, say, a $300 loan.

In addition to being a form of debt, cheques are also a type of money. I don't mean in the sense that cheques allow for the transfer of underlying bank deposits; rather, an uncashed cheque can itself be transferred between many different parties as a medium of exchange. This is something that younger people who only use credit cards and P2P options may not know, but if the issuer of the cheque writes "to bearer" in the pay to field, then literally anyone who is 'bearing' or holding that cheque can bring it into the bank to be cashed. Given that it grants universal access to underlying cash, a $100 bearer cheque might be transferred three or four time over the course of a few days, resulting in $300 worth of transactions being consummated rather than just $100. In the first of the two articles I linked to above, for instance, the owner of a small sari business says that it isn't uncommon for a bearer cheque to change hands as many as five times. 

Just a head's up. Even if you indicate the name of the recipient in the pay to field of a cheque you've written, say to John Doe, he can still use it as a medium for paying someone else rather than cashing it... without you even knowing. By endorsing the back of the cheque with his signature, John Doe converts it into a bearer cheque. This is called blank endorsement. Anyone he gives it to can now either bring it in to be cashed or continue passing it off in a long chain of transactions. In the U.S., these sort of cheques are called third-party checks, although banks tend to be a little leery about accepting them these days.

The use of cheques-as-money is promoted by laws that, like banknotes, grant them currency status. I touched on this distinction last week, but here it is again. Say that person A is carrying some sort of financial instrument in their pocket and it is stolen. The thief uses it to buy something from person B, who accepts it without knowing it to be stolen property. If the financial instrument has not been granted currency status by the law, then person B will be liable to give it back to person A. If, however, the instrument is currency, then even if the police are able to locate the stolen instrument in person B's possession, person B does not have to give up the stolen cheque to person A. We call these special instruments negotiable instruments.

Instruments like cash and cheques that have been granted currency status, or are negotiable, have a big advantage over those that haven't. Because they won't be on the hook for returning stolen negotiable instruments, shopkeepers and others can accept these instruments without having to set up costly verification procedures. This means these instruments will tend to be more liquid than those that are non-negotiable.   

A neat result of the transferability of cheques is that cheque payment systems are incredibly robust in the face of disasters and banking system shutdowns. Any direct transfer a bank deposit, say using a debit card or some other form of electronic fund transfer, requires that the parties to a payment to establish a  communications channel with their respective banks. If there is a problem with either of the banks, the merchant, or the connection itself, then the transfer can't go through. With a cheque however, there is no need to communicate with one's banker. A cheque is created entirely without the bank's say-so. Anyone is allowed to receive that cheque, it being their choice to either cash it or pass it along. Which means that if the banking system is on the fritz, cheque payments can proceed.

The most famous example of this robustness is the Irish banking strike of 1970. With the entire banking system shut, for six months post-dated cheques circulated as the main form of money. In a well-known paper, Antoin Murphy recounts how pub owners acted as evaluators of the credit quality of each cheque, an episode I once wrote about here.

Another nice property of cheques is that, like cash, they can be used by the unbanked. If someone receives a cheque, they can go to the issuer's bank and cash it, even if they don't have a bank account. Alternatively, they can simply endorse the back of the cheque and spend it on as a medium of exchange.

This combination of negotiability, robustness, openness, and decentralization means that long before bitcoin and the cryptocoin revolution, we already had a decentralized payments system that allowed pretty much everyone to participate and, indeed, fabricate their own personal money instruments!

Was there ever a more versatile payments instrument than the cheque? Because you can write on them, a whole language of cheques has emerged, allowing for significant customization. By putting crossings on cheques, like this...

...the cheque writer is indicating that the only way to redeem it is by depositing it, not cashing it. This means that the final user of the cheque will be easy to trace, since they will be associated with a bank account. Affix the words non-negotiable within the cross on the front of the cheque and it loses its special status as currency. Should it be stolen and passed off to an innocent third-party, the victim can now directly pursue the third-party for restitution. To even further limit the power of subsequent users to use the cheque as money, the writer can indicate the account to which the cheque must be deposited.

This language of checks can be used not only by those that have originated the cheque, but also by those that receive it in payment. On the back of any check, any number of endorsements can be written, effectively allowing for the conversion of someone else's payment instructions into your own unique medium of exchange.    

In summary, while the popularity of the cheque has certainly been declining over the last few decade, it is still hanging in there—and that's because it seem to be providing some unique services that haven't yet been replicated by cheaper, digital alternatives. While those in the fintech space often smirk at cheques at as an outdated payments option inevitably doomed to extinction, they might be better served trying to replicate some of these features instead.

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.


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.


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.


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":


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.

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?


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.


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:


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.