Friday, November 18, 2016

A modern example of Gresham's Law

Sir Thomas Gresham

Anyone who makes an effort to study monetary economics quickly encounters the concept of Gresham's law, or the idea that bad money can often chase out good. Gresham's law is usually used to explain the failures of bygone monetary systems like bimetallic and coin standards. But the phenomenon isn't confined to ancient times. I'd argue that a modern incarnation of Gresham's law is occurring right now in Zimbabwe.

Zimbabwe's stock market has blown away all other stock markets by rising 30% in the last month-and-a-half. The chart below compares the Zimbabwe Industrial index to the U.S. S&P 500, both of which are denominated in U.S. dollars. I'd argue that the extraordinary performance of Zimbabwean stock is an instance of Gresham's law. With the imminent arrival of newly printed Zimbabwean paper money, known as bond notes, "bad" paper money is poised to chase out "good" money, stocks being one of the few places where Zimbabweans can protect their savings.


What follows is a quick summary of bond notes (alternatively, read my two earlier posts). The Mugabe government, which began discussing the idea of a new paper currency earlier this year, says that it will issue low denomination bond notes into circulation before the end of the November. Recall that Zimbabwe has been using U.S. dollars since 2008 after a brutal hyperinflation destroyed the value of the local currency. The regime claims that a $1 bond note will be worth the same as a regular $1 Federal Reserve note. It says it has received a U.S. dollar line of credit from the African Export-Import Bank that will guarantee the peg.

Enter Gresham's law, which says that if two different media circulate, and the government dictates that citizens are to accept the two instruments at a fixed ratio—say via legal tender laws—then the undervalued medium will disappear leaving only the overvalued one to circulate. So called bad money drives out good.

Medieval coinage systems were often crippled by Gresham's law. For instance, say a new debased silver penny was introduced into circulation along with existing pennies. Because it contained a smaller amount of silver, the new penny was worth less than the old. However, legal tender laws required that all pennies be accepted without discrimination in the settlement of debts. Medieval debtors would thus always prefer to discharge debts with new pennies rather than old ones since they would be giving up less silver. The result was that only "bad money," or debased coinage, circulated. Because "good money," or undebased coinage, was undervalued, people either hoarded it, sent it overseas, exchanged it on the black market at its true value, or melted it down.

The same conditions that created Gresham effects in medieval times are emerging in modern day Zimbabwe. Rather than two different medieval coins, we've got two different types of dollars; bond notes and regular U.S. cash. The next ingredient for Gresham's law is a decree that dictates the rate at which people are to accept the two instruments. In Zimbabwe's case, the government has already declared that bond notes (once they appear) are to be legal tender along with U.S. Federal Reserve notes, which means that Zimbabwean creditors will have to accept bond notes at par as a means of discharging all debts, even if they'd prefer the genuine thing.

Since a chequing deposit is a debt incurred by a bank to a depositor, this means that Zimbabwean banks can—in theory at least—meet depositors' demands for redemption by providing bond notes. So a Zimbabwean bank deposit is no longer just a claim on actual dollars, but a claim on some mysterious as-yet unissued Zimbabwean government liability.

The last ingredient for Gresham's law is an overvaluation of one of the two media. In Zimbabwe, this will most likely occur as the market value of bond notes falls below that of genuine U.S. dollars. While many countries maintain successful currency pegs to the U.S. dollar, they have the resources to do so. I'm skeptical that the isolated and corrupt Mugabe regime has the resources to pull a peg off.

Bond notes have yet to be issued, but because existing bank deposits—or electronic dollars—are likely to be payable in this new paper currency, we can think of deposits as a surrogate for the bond note. The first bit of evidence that Zimbabwe has run into Gresham's law is that physical U.S. dollars are beginning to disappear from circulation, replaced entirely by electronic dollars. Why might this be happening? Start with the assumption that Zimbabwean bank deposits have become "bad," meaning they are worth less than actual physical dollars. If a Zimbabwean citizen needs to buy $100 in groceries, and the grocer is required by law to accept deposits and cash at the same rate, our citizen will naturally spend only overvalued deposits and hoard "good" and undervalued cash.

In fact, we have direct evidence that deposits have become "bad". In the black market, dealers will only sell physical cash at a premium. I've seen anywhere from 5% to 20% mentioned.

More evidence is provided from the stock market. The shares of Old Mutual, a global financial company, trade on both the Zimbabwe Stock Exchange (ZSE) and the London Stock Exchange (LSE). Because investors have the ability to deregister their shares from one exchange and transfer them for re-registration on the other, arbitrage should keep the prices of each listing in line. After all, if the price in London is too high, then investors need only buy the shares in Zimbabwe, transfer them to London, sell, and repurchase in Zimbabwe, earning risk-free profits. If the price in Zimbabwe is too high, just do the reverse

Oddly, Old Mutual trades in London for around $2.30 per share (after converting into US dollars) whereas it is valued at $3.20 in Zimbabwe. Here's the article that first tipped me off to this. As the chart below shows, this rather large gap has progressively emerged as the introduction of bond notes becomes more likely. Why is no one arbitraging the difference by purchasing Old Mutual in London for $2.30, then transferring it to Zimbabwe to be sold for $3.20? The large discrepancy likely reflects the growing risk that any dollar sent to Zimbabwe is likely to be trapped and re-denominated into a bond note.


The ratio of the two Old Mutual listings implies that the exchange rate between genuine U.S. dollars and dollars held in Zimbabwe is around 0.72:1, i.e. one Zimbabwean U.S. dollar deposit is only worth 72 cents in genuine U.S. dollars. While transaction costs and other frictions may explain part of the gap, this is still an incredibly wide discount.

Those with long memories will remember that during Zimbabwe's last hyperinflation, the cross-rate between Old Mutual listings was a popular way to measure the true exchange rate between the hyperinflating Zimbabwe dollar and the U.S. dollar. The official rate maintained by the Reserve Bank of Zimbabwe was not the true rate as it dramatically overvalued the Zimbabwe dollar. In the chart below of the hyperinflation, pinched from a paper by Steve Hanke, the Old Mutual Implied Rate—or OMIR—appears along with the black market rate for U.S. dollars. (I once discussed the OMIR here. The same trick was used in Venezuela using ADRs.)

From Hanke and Kwok

Once all the ingredients for Gresham's law are in place, inflation is never far behind. Because U.S. dollars are being undervalued, Zimbabweans will refuse to buy stuff with anything other than overvalued deposits. If they don't update their sticker prices, retailers will soon discover that they are receiving fewer real dollars than before. To maintain the real value of their revenues, they will have to mark up their prices, thus compensating for the fact that only "bad" money is flowing into their tills.

While retail prices are usually sticky, financial prices are not. And that may be why we've seen such a huge jump in Zimbabwean stock prices but little movement in Zimbabwean consumer price inflation. With Gresham's law beginning to push good money out of circulation, nimble owners of Zimbabwean shares are demanding a higher share price from potential share buyers in order to compensate for the risk of holding soon-to-be issued bond notes. Less nimble retailers have yet to demand this same compensation from their customers. Don't expect this to last; consumer price inflation can't be too far behind asset price inflation.

Sunday, November 13, 2016

Modi's demonetization: chaos is a feature, not a bug


Prime Minister Narendra Modi's aggressive demonetization of the 500 and 1000 rupee note is causing plenty of chaos in India. A general shortage of money has emerged, massive lineups have formed at banks, and cash-based business has come to a standstill. All this would seem to indicate that the process has been ineptly carried out. But I'd argue that the problems listed above are exactly what one should expect of a well-designed aggressive demonetization. Chaos is a feature, not a bug.

As I mentioned in my previous post, a regular demonetization isn't meant to harm anyone. To ensure that no one is left behind, legacy note are gradually replaced with new ones, a process that often takes decades to carry out. See for instance the below pamphlet published by the Bangko Sentral ng Pilipinas (BSP), the Philippines central bank. It shows a slow and staged approach to replacing old peso notes with new ones. The goal of an aggressive demonetization like Modi's is exactly opposite: to leave people behind. To get this effect, the demonetization has to begin suddenly and end quickly.



Why didn't Modi make more preparations for the retirement of the Rs 500 and 1000 note? For instance, to reduce lineups at banks and ATMs the Reserve Bank of India could have begun supplying banks with extra 100 rupee notes several weeks ago in order to ensure that there was sufficient supply come November 8. And maybe the RBI could have nudged banks to purchase more safety deposit boxes to hold cash and hire extra staff to handle the rush.

Or take ATMs. One reason for lineups is that with the demise of the 500 and 1000 note, ATMs are running at a fraction of their capacity.  Indian ATMs have four "cassettes", each holding around 2000 notes. Two cassettes are typically configured for the old 500 rupee note, one for the legacy 1000, and one for the still-existing 100. They typically do not dispense 50s. Thus the maximum an Indian ATM can provide in a post-demonetized India is one cassette worth of 100s, or 200,000 rupees (US$3,000). If everyone in the lineup removes 2000 rupees, the daily limit, that means just 100 people can be served. That's peanuts.

To get ATMs up to full capacity, all four cassettes need to be dispensing some combination of new 500 notes, 2000 notes, and/or existing 50 and 100 notes. The problem is that each ATM cassette need to be re-calibrated to hold a certain denomination since notes are not uniformly shaped. With every single ATM in the country needing to be modified, and only so much staff trained to do so, it's taking a lot of time.

So why didn't the government begin working with ATM companies a few months ago to make all the modifications in time for November 8? This would have surely reduced the awful indignities that regular Indians must undergo as they wait for hours to withdraw cash.

Unfortunately, any attempt to modify ATMs ahead of time would have caused Modi's aggressive demonetization to fail. In order to inflict maximum damage on those who depend on "black money" (i.e. income obtained illegally or not declared for tax purposes),  an aggressive demonetization needs to be executed suddenly. If rumour gets out that a demonetization is about to occur, the element of surprise will be lost. Those working in the underground economy will simply switch their high value banknotes into low ones ahead of the demonetization, thereby avoiding being damaged. And of course it is the rich, not the poor, who have the best networks for gleaning information. To reduce the potential for information leaks, the number of people 'in the know' needs to be kept to a minimum, and this means that all large-scale preparation—including a huge reconfiguration of the ATM network—must be avoided.

So if you support the idea of a demonetization—specifically one that is designed to hurt the underground economy and, in so doing, draw people into the taxed economy--then you should just accept that this was always going to be a messy affair. If it had been a smooth one, then that would have been a sign that it wasn't being effective.
  
Once the dust is settled, India will be made better off by the demonetization. While many Indians in the underground sector will grudgingly comply and deposit their funds in an account only to withdraw that same amount in new notes later, others will keep their funds in the banking system. To change, people sometimes need to be prodded. This should be a shift in the right direction given that a banked economy is stronger than an unbanked one.

My back of the envelope calculation tells me that the demonetization will generate real pain on the underground economy. Consider that there are Rs 12.2 trillion worth of 1000 and 500 notes in circulation, or US$181 billion (source). Assume that 40% of these notes, or Rs 4.9 trillion (US$72.7 billion) circulate in the dark economy and lack a paper trail. Further assume that thanks to Indian ingenuity, or jugaad, half of the black money will sneak through the demonetization. That still leaves the remaining Rs 2.4 trillion, or US$36 billion, stranded. That's a painful writeoff!

To build and effectively run a nation, a government needs to be able to efficiently collect taxes. Many will shrug off the immense losses caused by the demonetization and go back to using cash as a way to evade to avoid the tax man, especially now that the government has (somewhat puzzlingly) introduced a new 2000 rupee banknote. But a large enough contingent will migrate to the tax-paying economy for good. Once bitten, twice shy.

Tuesday, November 8, 2016

Aggressive demonetizations


Prime Minister Narendra Modi surprised Indians today by announcing that India's highest denomination notes, the 500 and 1000 rupee, will cease to be legal tender. On first blush, India seems to be enacting Ken Rogoff's idea of cutting down on criminality and tax evasion by phasing out high-denomination notes, which I recently discussed here.

But this isn't the case. Rather than removing the Rs. 500, the Reserve Bank of India is replacing it with a new bill. Furthermore, it will also be issuing a Rs. 2000 note, a new highest denomination note. What India is doing is enacting what I'll call an aggressive demonetization. I'd argue that this is an alternative (though not mutually exclusive) idea to Rogoff's. Both schemes are intended to create a logistical nightmare for money launderers; but whereas Rogoff's entails altering the denomination structure of banknotes to get this effect, Modi's aggressive demonetization keeps that structure intact while using note redemption and re-issuance as its lever.

Demonetizations are usually non-aggressive drawn-out affairs. For instance, when Canada announced that it would withdraw its $1000 note, it gave Canadians an eternal window to bring them in for redemption. The $1000 remains legal tender in Canada, meaning that it can be used to discharge any debt. As another example, take the euro. The introduction of the euro meant an end to all the national European currencies. While each of these currencies lost legal tender status in 2002, many enjoy an unlimited time frame for conversion into euros, including the Deutsche mark and Belgian franc. See below:


India's demonetization is an aggressive one because legal tender status is to be removed immediately and the time limit for redemption is incredibly tight and scripted. Here is Modi's announcement:


To summarize, Indians have just a few weeks to exchange old notes for new ones at banks or post offices. Proof of ID is required and switches are limited to Rs 4000, around US$60. There is no size limit for directly depositing old notes in bank of post office accounts. But of course, this means that the depositor's identity will be known by the bank and transactions will be traceable. Deposits can be made at banks until the end of the year. After that date, the central bank will exchange old notes until March 31, 2017, although this will require some sort of declaration of origin.

The point of all this is to suss out anyone with large amounts of cash that has been earned from dubious sources. Say you've got one million paper rupees, worth around US$15,000. If you've got the receipts to show why you have that much cash, then you can safely bring it to the bank. But if you don't, you'll have to get rid of it as quick as you can by spending it, say on gold (or any other good). However, this will be an incredibly difficult task given the fact that there will be many other Indians trying to spend their undocumented Rs. 1000 and Rs. 500 notes on gold at that very same time, and only a limited number of gold dealers willing to accept them. After all, any gold dealer who accepts notes now inherits the same problem: what to do with newly-demonetized banknotes. Any gold dealer who starts to bring in larger-than-normal amounts of paper money to their bank for redemption will surely face questions. To compensate for this risk, gold dealers will either impose a large penalty on cash payments or they'll stop accepting cash altogether.

Some undocumented rupees will no doubt be successful in evading Modi's aggressive demonetization, but large quantities will be left stranded. Significant damage will have been dealt to anyone working in the underground economy.

As Tony Yates points out, the most aggressive demonetization in history was probably Saddam Hussein's recall of the Swiss dinar in 1993. Swiss dinars were Iraqi banknotes printed on high quality paper whereas dinars printed after the 1992 U.S. invasion were issued on shoddy and easily counterfeitable material. On May 5, Saddam announced that all Swiss dinars had to be turned into the central bank for an equivalent amount of post-war currency over a tiny six day exchange period. He then proceeded to close the border, preventing Kurds and other foreigners from making the switch. Huge amounts of currency was left stranded, although unlike the Indian situation it was foreigners, not criminals/tax evaders, who were the target. (I went into the Iraq story here. The Burmese kyat and North Korean won demonetizations of 1985 and 1999 were also quite awful, see here.)

If you think Modi's strategy is new, or confined to developing nations, think again. A few years ago, Sweden carried out out a (somewhat less) aggressive demonetization in order to catch illicit cash users. In 2012, the Riksbank announced that all  1000 krona banknotes without foil strips were to be declared invalid by the end of 2013 (each 1000 krona note is worth around $110). Until December 31, 2013, Swedes were permitted to get rid of 1000 krona notes by either using them to buy stuff or depositing them at a bank. To tighten the noose, no anonymous conversions of old notes into existing notes were permitted. Swedes had to have bank accounts, and therefore had to forgo their anonymity, in order to rid themselves of old currency.

Anyone who's seen Breaking Bad knows that laundering money takes time and patience. A Swedish criminal with ten million dollars worth of high denomination krona was suddenly faced with a significant problem; how to get this stash back into the legitimate economy within 400 or so days.

How tough was this challenge? We know that at the start of 2013 there were fourteen million 1,000 krona notes in circulation (worth 14 billion SEK, or US$1.6 billion). After the expiry date, the Riksbank noted that there were still some three million 1,000 krona notes that had not been redeemed, worth around $330 million. This gives a rough indication of the value of banknotes left stranded by criminals and tax evaders, around 25% of all notes outstanding.

After the December 31, 2013 deadline, the Riksbank itself offered to redeem invalid banknotes (it still does), albeit for a 100 krona fee. However, criminal and tax evaders have no doubt steered clear of this offer as the declaration form includes the following question:


Sweden is the only country in the world in which cash holdings are in decline. Might this have had something to do with the damage inflicted by the Riksbank's 2013 demonetization on the psyche of participants in the underground economy?

So let's compare the advantages of Modi's aggressive demonetization to Rogoff's abolition of high denomination notes. If an aggressive demonetization is chosen, then a central bank gets to enjoy high profits, or seigniorage, since it continues to issue an extended range of banknotes, unlike Rogoff's abolition. The more float, or 0% cash liabilities that remain outstanding, the more interest the central bank will earn on its bond portfolio. The central bank also earns significant earnings from 'breakage.' All illegitimate banknotes that never get redeemed are recognized as a one-time unusual gain on the central bank's statement of income. Finally, people engaging in legal activities who enjoy the anonymity afforded by high denomination notes still get to use them; they don't under Rogoff's abolition.

Unfortunately, an aggressive demonetization can only be effective for a little while. It's hard to see why people won't quickly re-adopt the highest denomination note as a medium for evading taxes and engaging in illicit activity. In response, the central bank will have to enact an followup demonetizations every few years, but of course the underground economy will do its best to anticipate these by moving into low-denomination notes or foreign paper whenever it suspects something is afoot.

To create a logistical nightmare for money launderers, maybe Peter Garber's idea beats Rogoff's abolition and Modi's demonetization?:
"Why not simply increase the physical dimensions of high-denomination notes without jumping through the flaming hoop of elimination? Before 1929, U.S. currency was 40 percent physically larger than it is now. Restoring that size or making it even larger would instantly work the wonders of decades of inflation. The iron law for subverting illicit economies: a percentage increase in physical note size is equivalent to the same percentage increase in the price level."

Sunday, November 6, 2016

Thoughts on Rogoff's 'Curse of Cash'

The US$5000 banknote, destroyed in 1969 along with the $10,000, $1000, and $500 notes

With the publication of his new book The Curse of Cash, economist Ken Rogoff has ignited a big debate over the future of paper money. Both the book, which is packed with information and accessible to a mainstream audience, and Rogoff's series of blog posts are well worth reading, even if you already disagree with his premise that the way the world currently handles cash needs to be modified.

The key observation motivating Rogoff's book is this one: with $1.3 trillion worth of U.S. currency in existence, a back-of-the-envelope calculation says that the average four person family should be holding around $16,800 in cash. However, this simply doesn't reflect the personal experience of most Americans. Indeed, 2012 survey data shows that consumers generally report holding just $56 per person, leaving the majority of cash unaccounted for. Nor is this anomaly confined to the U.S. Given $78 billion in Canadian currency outstanding, a four person family in Canada should hold around $6,000. Instead, survey data shows the average person only holds a median $38 in their wallets. The same pattern occurs in Europe, Japan, Australia, and elsewhere.

According to Rogoff, much of the unaccounted cash is being held by those who participate in the underground economy, both by those engaged in criminal activity and those employed in legal activity (dentists, contractors, retailers, etc) who use cash as a way to avoid taxes. Rogoff's premise is that if we can alter the institution of cash, then maybe we can flush some of these people out of the underground economy and back into the legal, tax-paying economy.

The denomination structure of cash

Having read through many of the criticisms that Rogoff has received over the last few months, I've noticed that there is a tendency on the part of his opponents to frame this debate as an either/or one. Either keep cash and the personal liberty it provides—anonymity and uncensored access to the payments system—or sacrifice cash and in the process throw out that liberty.

This mischaracterizes the debate. Rogoff isn't advocating an end to cash or the liberties that go with it. Rather, he wants a modification of the existing denomination structure of banknotes such that the $100, $50, and $20 are removed while the $1, $2, $5 and $10 are left in circulation. Over the long-term, he proposes replacing these small bills with heavy coins. The set of personal liberties afforded by cash will be allowed to live on, albeit through the reduced convenience of small banknotes like the $10.

The term denomination structure refers to the top and bottom-most denominations issued by the monetary authority, the spacing between denominations, and the point at which the transition between coins to notes begins. As per Tyler Cowen's second law ("There is a literature on everything"), academics have been writing on the topic of optimal denomination structure for a few decades. The goal of this literature is to find the range and spacing of notes/coins that reduces the amount of monetary work that all participants in a currency system must engage in. By monetary work, I mean the effort that goes into printing money, carrying it, storing it, counting it, making calculations with it, paying with it, and breaking it into smaller amounts. If a denomination structure can be found that allows everyone do a little bit less work, society is much better off.

Rogoff takes the opposite approach. His abolition of large denomination banknotes is designed to increase rather than reduce the amount of monetary work that users of cash must engage in. After all, ten thousand dollars worth of Rogoff's preferred highest value note—the $10 bill—requires far more effort to count, store, and lug around than a hundred $100 bills.

Rogoff believes that the increase in monetary work brought about by a reduction in the purchasing power of the highest value note can be a useful filtering mechanism for improving societal welfare. Assume that there are "bad" and "good" users of cash, the former being criminals and tax evaders and the latter being regular people who want to enjoy the speed, anonymity, and convenience of paper money. "Good" cash users only need small quantities of notes from time to time and therefore will only be slightly inconvenienced by the increase in monetary work caused by a constriction in the purchasing power of the highest denomination note. "Bad" users tend to make regular use of large amounts of cash, and will therefore be severely affected by a constriction.

While Rogoff's abolition won't stop crime or tax evasion, it will surely make these activities trickier. This should in turn push activity out of the non-taxed underground economy into the legal economy.

Burdening cash is the status quo policy  

These ideas aren't entirely novel. In fact, I'd argue that since the 1800s, the U.S. has been implicitly adopting Rogoff's strategy of increasing the amount of monetary work involved in using cash. The chart below illustrates both the nominal and real value (in 2015 dollars) of the U.S.'s highest denomination banknote going back to 1871.


In general, the purchasing power of the highest denomination note has been gradually declining. This has been mostly due to the fact that even as inflation erodes the dollar's value, American monetary authorities have chosen to avoid introducing new higher value notes. Nor is the U.S. unique in this respect. Correct me if I'm wrong, but I can't think of a single developed nation that has introduced a higher denomination note over the last fifty years.

In the U.S.'s case, the decline in the purchasing power of the highest denomination note hasn't been entirely due to the combination of inflation and a lack of new large value U.S. notes. Take a look at what happened in 1969. Throughout the 19th century the U.S. Treasury was an issuer of $10,000 certificates, a practice the Federal Reserve would continue after its founding in 1913. However, on July 14, 1969 the Fed announced that it would put an end to this tradition by destroying all $10,000, $5000, $1000, and $500 denominations, leaving the $100 as the U.S.'s largest denomination. It did so on the very same day that Richard Nixon launched his famous war on drugs. Although the Fed claimed that its decision was motivated by the declining usage of large value banknotes over the previous two decades (PDF pg 624), the timing indicates that Nixon's crime push must have been a big reason.

So largely through a policy of benign neglect (i.e. by passively allowing inflation to eat away at its purchasing power), the U.S. along with most developed nations have been gradually increasing the workload involved in using the highest value note. Assuming inflation of 2%, by 2095 or so the US$100 will buy as much as the $20 does today. By 2130, it will buy as much as the $10 does today.

Rogoff isn't content with the gradual approach to increasing monetary work. He wants to add a one-time increase in the level of monetary work involved in using cash. This would involve a quick Nixon-style "tightening" of the filter, removing in one fell swoop all denominations above the $10 bill. Put differently, rather than waiting till 2130 for the $100 bill to be worth $10, he wants this event to happen now. Once a Rogoff-style high denomination notes abolition has been carried out, inflation will once again determine the rate of increase in the monetary work involved in cash usage.

So ultimately, the great cash debate isn't about cash vs. cashlessness. For decades developed nations have been gradually increasing the burden of using banknotes. Should we stick with the status quo or speed things up a little?

The case of Sweden

Rogoff makes one mistake in his book. As many people may know, Sweden is the only nation in which cash usage is in decline, a precedent Rogoff wants other nations to emulate. Several times in his book, Rogoff mentions that the Swedes have removed their highest denomination note, the 1,000 kronor, and that this removal helps to explain the nation's dramatic drop in cash usage. But this isn't the case. All that the Riksbank did was replace the old 1,000 kroner note in 2013 (which had Gustav Vasa on it) with a new Dag Hammarskj√∂ld version. The 1,000 is still alive and kicking.

This puts Rogoff in a somewhat uncomfortable position. Some other policy than the one he prefers is at work in the very country he puts forth as an example for all to follow. I think I might know what this policy is. As discussed in this excellent post by Martin Enlund, the Swedes implemented a tax deduction in 2007 for the purchase of household-related services such as the hiring of gardeners, nannies, cooks, and cleaners. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.

Enlund's chart shows how the decline in krona outstanding closely coincides with the timing of the introduction of RUT and ROT:


Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to claim their tax credits, many of these transactions would have been pulled into the open. Note the rise in RUT and ROT payments on Enlund's chart, for instance. Calleman reports that  the number of customers using registered domestic service companies rose from 92,000 in 2008 to 537,600 in 2013. Since the implementation of RUT and ROT, Swedish opinions on paying for undeclared work have changed dramatically. In 2006, 17% said it was completely wrong to to hire undeclared labour. In 2012, and 47% felt it was completely wrong.

Using data from a survey of the general public conducted by the Swedish tax authority, the charts below show how much knowledge Swedes have about those around them engaged in tax evasion. In the bottom chart, the number of Swedes who are aware of businesses that are evading taxes has fallen from 27% in 2007 to just 9% in 2013. That is an especially large and fast decline. As the tax authority points out, RUT and ROT is the likely explanation.



Rogoff himself maintains in The Curse of Cash that the largest holdings of cash in the underground economy are due not to criminals but those engaged in legal work (like contractors) who are avoiding taxes. By cutting down dramatically on tax evasion among those engaged in household services and repairs, the RUT and ROT deductions may explain a significant chunk of the decline in Swedish currency in circulation.

This post has gone long enough, so let me get to my final point. I agree with Rogoff's general point that it makes sense to burden cash users with ever more work since this burden disproportionately falls on heavy users like criminals. But Rogoff hasn't yet convinced me that the status quo policy of gradually increasing the workload involved in cash usage (via inflation) needs to be sped up by a sudden removal of every bill above the $10. After all, the Swedes are setting an example of how a policy of gradualism can be twinned with tax policy in order to get some of the very effects that Rogoff advocates, namely pulling people out of the underground economy into the legal economy.

Is the Swede's approach better than Rogoff's high denomination note abolition? I'm not sure, I don't know enough about the economics of tax policy to arrive at a firm conclusion. But it seems to me that a more complete analysis of the real reasons for Sweden's cash miracle needs to be conducted before we go about killing the $20, $50, and $100.

Thursday, October 27, 2016

How anonymous is cash?

Dutch 10 guilder note. Holland and Lebanon are the only countries to have issued banknotes with bar codes.

One of the interesting things that we've all learnt about Bitcoin is that it isn't actually anonymous, it's pseudo-anonymous. While anyone can deal in bitcoins without providing personal information like a phone number or photo ID, all bitcoin transactions are broadcast to the public. By analyzing these transaction patterns, it may be possible to flush a user's true identity out into the open.

Bitcoin is an attempt to digitally replicate many of the features of the old fashioned banknote, but even banknotes are to some degree pseudo-anonymous. Each banknote has a unique serial number on it. By tracking serial numbers, it may be possible to connect a note to a noteholder and thereby destroy their anonymity. The process of unveiling note users occurs most often in kidnapping cases. When their young son was kidnapped in 1932, the Lindbergh family paid a $50,000 ransom in non-sequential banknotes. In an effort to identify the kidnapper, a list of the serial numbers of notes used to pay the ransom was published in the New York Times and circulated in pamphlet form to banks all over the New York area. Anyone who found the note was to immediately alert the authorities, this information being potentially useful in helping to triangulate the guilty party:

Published list of banknotes the Lindbergh's used to pay the ransom

Kidnappers prefer to be payed in non-sequential numbered bills. The Lindbergh kidnapper is no exception, writing in one of several ransom notes: "Don't mark any bills or take them from one serial nomer [sic]." The reason for this is that it's easy for a bank teller to cross reference incoming notes against a list that contains an easy-to-remember range of sequential numbers. When serial numbers are randomized, the list becomes much harder for the human eye to parse; just try to work through the above example. The non-sequential nature of the ransom payment probably explains why only a few of the Lindbergh blacklisted notes were found...

...at least at first. The final pinpointing of the Lindbergh kidnapper really only became possible when Franklin D. Roosevelt decided to temporarily take the U.S. off the gold standard in 1933. Somewhat serendipitously, the authorities who were helping the Lindbergh family had decided to pay the 1932 ransom in gold certificates, a Treasury-issued instrument that was redeemable in a fixed quantity of gold. At the time, gold certificates circulated along with a motley crew of other private and government-issued note types including Federal Reserve notes, U.S. Notes, Federal Reserve Bank Notes, silver certificates, and National Bank Notes (see here).

As part of the process of going off the gold standard, Roosevelt issued Executive Order 6102 requiring all Americans to bring in their gold, gold coins, and gold certificates to be exchanged for Federal Reserve notes. The Lindbergh kidnapper would only tender a few of his gold certificates in 1933, perhaps worrying that bringing in all $50,000 at once would attract attention.

Subsequent to Roosevelt's Executive Order, gold hoarding became an illegal act. So when the kidnapper bought gas with a $10 gold certificate in September 1934, the gas station attendant—probably worried that he might not be able to deposit it—wrote the license plate of the car on the note. Three days later the station managed to deposit the note at its bank where it was successfully cross-referenced against the black list, a much easier process now that the population of gold certificates was so small. Bruno Richard Hauptmann, the kidnapper, had been unveiled.

Using serial numbers to unveil identity requires the cooperation of private banks as well as some luck, in the Lindbergh's case the coincidental alteration of the monetary standard. However, there is no reason that central banks themselves can't be aggressive in monitoring serial numbers. In 1973 the Dutch central bank, the De Nederlandsche Bank (DNB), set up the first real-time database of banknotes in circulation. All banknote serial numbers are registered in the database. As used banknotes are brought into DNB processing points each day, machines read their serial numbers and update the database to indicate that these notes are no longer in circulation. When these same notes are paid out to banks the next day, the system once again updates its database to indicate that they have re-entered circulation. Over time, the system gleans information about the paths taken by each individual note, including how long it stays in circulation and its geographical exit point. It also provides excellent protection against counterfeits. If the DNB detects two banknotes entering its system with identical serial numbers on the same day, then one of them is by definition a fake.

While many central banks were "intrigued" by the Dutch registration system none of them actually implemented the concept (see page 263 of pdf). As of 2012, the DNB  remains the only central bank to register banknotes on a daily basis, a fact which I find kind of shocking. Why have serial numbers if not for tracking? Decoration?

The upshot is that if you had to choose a place to be kidnapped, Holland would probably be it. As long as the serial numbers are recorded by the authorities before the ransom is paid, then the DNB's registration system can be mobilized to catch kidnappers. For instance, the DNB claims it was instrumental in catching the kidnapper of Gerrit Jan Heijn, an heir to the Albert Heijn supermarket empire, in 1987. When the kidnapper spent NLG 250 to buy groceries, the note was soon deposited at the DNB and read into the database, at which point authorities had enough information to trace it back to the commercial bank and then the supermarket.

Interestingly, there are a number of private banknote trackers on the internet, the most well known of which is Where's George. A user logs into the website and registers a U.S. banknote by entering its serial number. When someone else subsequently registers the same banknote, the ‘route’ of the bill is displayed. Where's George tracks around 266 million bills. EuroBillTracker, the equivalent for the euro, tracks around 160 million notes. Below is a map showing the "hits," or connections it has established over the last week:

Hits registered by EuroBillTracker

So cash is somewhat less than anonymous, or anonymous-ish, since behind the curtain an organization like the DNB may be recording serial numbers, and this data might be useful in learning about users' real life identities. By tracking serial numbers more robustly, the anonymity of cash can be further eroded. Imagine a Where's George world where each time a bills is used, the receiver is required to submit the serial number to a government-run central registry. If so, the banknote system would have attained the same level of pseudo-anonymity as bitcoin, where anyone is free to transact using banknotes but transaction chains are fully public.

We could go further and imagine a world where a central bank like the DNB requires that the circulation of high denomination banknotes, say the €200 note, be confined to 'legitimate' channels only. Cash is perpetually being withdrawn from the central bank, used in payments, and then redeposited at the central bank. To confine €200s to legitimate channels, the DNB would simply announce that it intends to limit redeposits to those notes that have fully verified transactions histories. Verification means that when someone receives a €200 note, they must register it by submitting its serial number to the central bank via an app along with some sort of proof of identity.

When someone fails to either register a note or provide adequate identification, that note effectively falls out of the system. After all, because the DNB won't allow a note with an incomplete chain of verified transactions to be redeposited, banks will refuse to accept any note that hasn't been registered by its current owner. And knowing that banks won't accept them, neither will retailers. Bills that have fallen through the cracks will only have value in an alternative black market where they'd likely trade at a large discount to legitimate notes. Incidentally, establishing a verification system for €200s is very similar to Ken Rogoff's idea of abolishing high denomination notes, except instead of withdrawing €200s, they'd be allowed to stay in circulation in 'cleansed' form.

Thanks to a distinctive earmark—their serial number—the anonymity of banknotes is never fully assured. While serial numbers are rarely used these days for tracing, who knows what might happen in the future. Privacy advocates can take some comfort in the fact that, unlike paper money, coins have no distinctive markings and are therefore capable of serving as a purely anonymous exchange medium. Unfortunately coins have a low value to weight ratio so lugging the stuff around is a pain. The Swiss and Japanese stand out here for issuing the highest value coins, the five franc coin and 500 yen coin respectively, each worth around US$5.

As for cryptocoin fans, tomorrow Zcash will be launching. Whereas the entire history of bitcoin transactions is public, Zcash succeeds in hiding everything about the transaction. That's true anonymity.

Monday, October 17, 2016

The strange mania for Swiss National Bank shares


The shares of the Swiss National Bank (SNB), Switzerland's central bank, have almost doubled since July, despite there being no real news. Yep, you read that right, the SNB is listed on the stock market. There are four other central banks with listed shares: Belgium, Japan, Greece, and South Africa. I discussed this odd group back in 2013.

Why are SNB shares catapulting higher? This is a staid central bank, after all, not a penny stock.

Let's look at the fine print. Swiss National Bank shares aren't regular shares. To begin with, the dividend is capped at 6% of the company's share capital. The SNB was originally capitalized back in 1907 with 25 million Swiss francs, an amount that hasn't changed in 109 years. Which means that the dividend is, and always has been, limited in aggregate to a minuscule 1.5 million francs per year (about US$1.5 million). Because this amount must be divvied among the 100,000 shares, each share gets just 15 francs per year.

The SNB has faithfully paid this 15 franc dividend since its founding (apart from 2013, when it was omitted due to massive capital loss on its gold holdings). For instance, here it is paying the dividend throughout the 1980s:



Once the 1.5 million franc dividend is paid, Swiss law dictates that all remaining profits get sent to the Swiss central government and the cantonal governments. It further stipulates that if the SNB is to be liquidated, shareholders will only receive a cash payment equal to the nominal value of their shares. This means that if shares are trading for 1025 Fr, but there is residual firm value (after paying debtors) of 10,000 francs per share, well too bad—shareholders only get 1025 Fr.

Given these peculiar details, an SNB share isn't really equity; it's best thought of as a perpetual government bond with a 6% coupon, sometimes known as a consol. It throws off 15 francs per year for the rest of time. With the SNB as issuer, these securities are pretty much risk-free.

The math behind SNB shares is straightforward. Just use the Finance 101 formula for a perpetual bond, PV=c/r, or present value (PV) equals yearly cash flow (c) divided by yield (r). With annual interest payments of 15 francs and SNB shares trading at 2000 Fr, the yield comes out to 0.75%.

Here's what I think explains the rise in SNB shares. In July, an odd thing happened. The yield on the Swiss 50-year bond, the closest instrument in Switzerland to a perpetual government bond, fell below 0%. SNB shares (i.e. perpetual bonds) were themselves trading at around 1000 francs at that point for a yield of 1.5%. A few large investors probably began to ask themselves: Why the devil are we accepting a negative nominal return on our ultra long-term government bond portfolio if these other government bonds, which happen to be issued by the central bank and masquerade as shares, still have a positive yield? And so they started to buy SNB shares in quantity, driving the price up and the yield down.

This sort of thinking explains why SNB shares have risen, but not necessarily the explosive nature of the move. The shares haven't just risen by a few bucks, after all. They've almost doubled!

Let's take a closer look at the perpetual bond formula. If nominal interest rates fall from 1.5% to 0.5%, a fifty-year bond with a par value of 1000 francs and a 15 franc yearly coupon will rise from 1000 to 1,441 francs. Not bad, but compare that to a perpetual. For the same decline in rates, SNB shares will double in value from 1000 to 2000 francs. As rates continue to fall towards zero percent, the price of a perpetual goes parabolic. At 0.25%, the perpetual will be worth 6000 Fr, at 0.1% it trades at 15,000 Fr, and at 0.01% it sells for 150,000 francs. At 0.001%, they'd be valued at 1,500,000 francs each!

In the table below, I've illustrated the relative dynamic of a 50-year bond and a perpetual as rates fall to zero.
Price of a 50-year bond and perpetual at various interest rates

At the limit of 0%, SNB shares will have an infinite price. If all existing and yet-to-be-issued government fixed term bonds are guaranteed to lose money over the course of their existence, but there exists a government security that is guaranteed to perpetually offer a positive cash flow, then an investor will pay *any* amount of money to own those cash flows. There is no price to which SNB perpetual bond can rise that chokes off their demand.

The behavior of perpetual bonds at low interest rates *might* explain why SNB shares have gone hyperbolic. It also means that if Swiss rates continue to fall, the shares could have another double or two in the tank. So much for staid Swiss central banking.



Hat tip to Leon Oudejans for alerting me to the recent rise in SNB shares.

P.S. Does anyone know how rare perpetuals are, specifically perpetuals like SNB shares that don't provide the issuer with the option to call it? My understanding is that this sort of security just isn't issued anymore, at least not since British consols.

What the difference between an SNB share and a 1000 Swiss banknote? Not much, right? They're both perpetual bonds, one paying 15 francs a year, the other paying zero francs per year. If you were to write the number 1000 on an SNB bearer share, and 500 on a half share, and 100 on a fifth share, etc you'd have the entire series of Swiss banknotes. Cut the dividend on shares to zero, and won't banknotes and shares be exactly the same?

Here's a chart of the Bank of Japan, which is also a perpetual bond underneath the hood.

Wednesday, October 12, 2016

Bitcoin, drowning in a sea of credit card rewards


Satoshi Nakamoto kicked off his famous 2008 white paper with the line: "Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments." He created Bitcoin, a form of decentralized cash, to deal with this problem. But as Meltem Demirors points out, Bitcoin adoption seems to have peaked. Eight years after Nakamoto published his paper, not many people are using the stuff as money.

Here's a way to get more people using bitcoins as money on the internet:

Commerce on the Internet has come to rely on a Visa/MasterCard pricing standard. Although a few online stores like Dell, Expedia, and Microsoft accept bitcoin payments, they still set their prices in terms of Visa/MasterCard dollars. Because the dominance of this pricing standard is preventing innovative money like bitcoin from emerging, it needs to be hacked.

The Visa/MasterCard standard

Credit card issuers aren't mere intermediaries. Along with their core payments offering, they sell a broad range of goods and services. This includes but is not limited to: 1) rewards in the form of points, air miles or cash back; 2) car rental and travel insurance; 3) warranty extensions; 4) coverage of goods purchased against loss/damage; and 5) price protection i.e. should the price of a good fall after you buy it, the card issuer refunds the difference.

Credit card issuers don't give all this stuff for free. Some of the costs are recouped by annual fees and interest on unpaid balances. But by far the biggest line item is something called 'interchange'. An interchange fee is a levy that merchants must pay to the credit card issuer each time a card is used. The better the card reward the larger the interchange fee. In Canada, for instance, the MasterCard World Elite interchange rate for internet transactions is 2.49%. Regular cards are docked interchange of just 1.61%. [source]

Retailers recoup interchange fees by passing them off to customers. The way they do this is to build interchange into sticker prices. In a world without credit cards, Dell accepts nothing less than $1000 for a laptop. But in an economy with credit cards Dell faces an average interchange rate of 2%, or $20 per laptop, reducing revenue-per-laptop to $980.

To recoup its costs, Dell marks laptop prices up to $1020.40. Of this amount, 2%, or $20.40, goes to the credit card issuer to cover the cost of the customer's rewards, insurance, warranty extensions, etc, leaving Dell once again with revenues of $1000/laptop. Dell doesn't actually tell us they are on-charging us for these things. They surreptitiously build this premium into the sticker price.

On the internet, every retail price has been marked up by around 2%. That's what it means to be on a Visa/MasterCard standard.

Bitcoin is being undervalued

The Visa/MasterCard standard has the effect of repelling bitcoin use.

Imagine Alice, a bitcoin user who wants to buy a laptop. In paying $1020.40 worth of bitcoin for a Dell, Alice effectively overpays. She gets the $1000 laptop but does not get the $20.40 in associated rewards, points, insurance, or price protection that are built into the laptop's sticker price. Rather, Dell gets to keep the $20.40 premium for itself, since it doesn't need to pay interchange on Alice's bitcoin payment.

Because retailers like Dell are undervaluing bitcoin, consumers like Alice are always better off using their credit card. The more rewards that credit card issuers add to their cards, the better the get at locking out bitcoin. This isn't just a problem with bitcoin and cryptocoins. The Visa/Mastercard standard has the potential to inhibit the adoption of other new media of exchange like mobile money.

No amount of code can hack the standard

If bitcoin could somehow be altered to pay rewards, cash back, and car rental insurance then it would be competitive with credit cards. This isn't a realistic option. Instead, the best fix is for retailers to offer bitcoin price discounts. If a Dell laptop retails online for $1020.40, bitcoin users should be charged just $1000 so that they aren't paying for points, rewards, car rental insurance and other benefits that they never get to enjoy. This would put bitcoin on an even playing field with credit cards.

How to convince retailers to offer bitcoin discounts? This isn't a problem that can be fixed by the bitcoin brain-trust making alterations to bitcoin source code. It's an interface problem: bitcoin hasn't been properly integrated into the real world, specifically into online shopping carts.

Cash has the same problem. The growing popularity of credit cards has led to the emergence of a Visa/MasterCard standard in the bricks & mortar economy. In a fully competitive economy retailers would compete to reduce their cash prices. However, retailers do not generally offer cash discounts, perhaps because they are worried about causing confusion, distrust, and delays at checkout counters (see discussion here). Alternatively, many retailers seem to believe that offering discounts is in contravention of Visa/MasterCard rules (it isn't.)

There is one big difference between cash and bitcoin. Cash lacks a community of users that can agitate for changes to the Visa/MasterCard standard. Central banks, which issue banknotes, don't really care that cash discounts aren't being offered because they lack a profit motive, and cash-using consumers, which tend to be poor or criminals, lack the means to organize. Lined up against cash is an incredibly powerful credit card lobby that has implemented all sorts of tricks (like prohibiting card surcharging) to prevent cash usage.

Unlike cash, Bitcoin boasts an active community of individuals and businesses with a strong interest in the success of the Bitcoin network. To hack the standard, this community needs to start agitating for discounts. Bitcoin payments providers Coinbase and Bitpay currently offer retailers the technology for setting bitcoin discounts. But Microsoft, Expedia, and Dell haven't taken them up on their offer, opting to keep the Visa/MasterCard standard in place. That's one place for activism to start. If the big three can be convinced to implement changes, this might be enough to kickstart an industry-wide practice of offering a 0.5 to 2% bitcoin discount. If the Bitcoin community succeeds in unbundling the Visa/MasterCard standard, it'll have leveled the playing field not only for itself but all subsequent forms of digital cash, whatever form they take.



P.S. I wrote a similar piece in 2015 on Bitcoin and the VISA/MasterCard standard. That piece focused on the superior stability of credit cards and the fact that credit card users, unlike bitcoin users, needn't incur foreign exchange costs since they spend most of their lives in the dollar universe. This version is more explicit about the reward side of the equation. All facets need to be integrated to determine how large of a bitcoin discount to be applied by retailers.

Thursday, October 6, 2016

Does money enjoy a home advantage?


Do citizens benefit by owning money that is pegged to the nation's own unit of account rather than a foreign unit of account?

Let's start by imagining a money that is not pegged to the national unit of account. Say that U.S. banking giant Wells Fargo establishes branches all over Canada. Instead of issuing chequing accounts that are pegged to the Canadian dollar, it decides that it will steal business from Canadian banks by issuing U.S. dollar-pegged chequing accounts to Canadians. Wells Fargo execs reason that the U.S. dollar is at least as stable as Canadian dollars, if not more so, and this could give their product an edge.

Further imagine that Wells Fargo is able to ensure that its U.S.-denominated money is just as liquid as that of competing Canadian money. Say that Canada's national ATM network is modified to dispense U.S. dollars to Wells Fargo cardholders. Retailers are convinced to accept U.S. dollar electronic payments, and so is Revenue Canada, the national tax authority. The upshot is that within Canadian borders, a U.S. dollar can do anything that a Canadian dollars can. Any Canadian in need of liquidity will be entirely indifferent between regular C$ deposits and Wells Fargo US$ deposits.

Let's also assume that shifting funds between U.S. and Canadian dollars is free, so Canadians who are paid in one unit have no compunctions about exchanging into the other. Apps and other technologies remove all inconveniences of calculating exchange rates. Finally, Wells Fargo's U.S. dollars are FDIC-insured and its Canadian branches have access to the Fed's discount window, making them just as safe as Canadian dollars.

This leaves just one difference between the two types of money; Canadian dollars are the unit of account. This means that retailers set prices in Canadian dollars, not U.S. dollars. Will this feature have any influence on whether Canadian consumers choose to open an account with Wells Fargo or stay with their existing bank?

Consumer prices are peculiar because, unlike asset prices, they stay constant for long spells of time. When examining the frequency of price changes for 350 categories of goods and services, Bils and Klenow found that prices tend to stay fixed for 4.3 months before they are updated.  Coin-operated laundry prices exhibited price spells of 79.9 months, driver's license fees 56.3 months, and newspapers 29.9 months (see below). On the short end of the spectrum, the price spell for gas is just 0.6 months, eggs 1 month, and women's suits 1.6 months.

Source: Bils & Klenow

One reason for this stickiness is that retailers are said to have made an "invisible handshake" with consumers that requires them to avoid raising prices when demand suddenly increases. Retailers bind themselves to this implicit contract because they do not want their loyal customers to view them as being unfair, spitefully bolting to the competition when prices are adjusted. Customers may prefer stable nominal prices because these allow them to carefully match their daily and weekly spending plans with the money currently available in their accounts. Put differently, if you've got $100 in your account, and the set of retailers at which you shop have promised not to budge on pricing for a few weeks, you can determine ahead of time what bundles of goods you can afford. Without the sticky price "handshake," you're in the dark.

So money that is denominated in the unit of account comes with a major ancillary benefit. In Canada's case, the nation's retailers have agreed to offer Canadian dollar owners a convenient planning mechanism, much like a day planner or personal organizer. This mechanism provides anyone who owns Canadian dollars around 4.3 months of  uncertainty alleviation within national borders.

Whereas Canadian sticker prices are characterized by long price spells, the U.S. dollar prices faced by Wells Fargo's Canadian customers will fluctuate by the second. To see why, consider that when a customer wants to pay in U.S. dollars, they will have to indicate their preference at the checkout counter. The retailer inputs the Canadian dollar sticker price of the good, multiplies it by the USD/CAD exchange rate, and arrives at the U.S. dollar price. The foreign exchange market is a 24 hour "flex-priced" market, so the exchange rate--and thus the U.S. dollar sticker price of goods--will always be fluctuating.

Wells Fargo money will therefore not be able to provide the same set of uncertainty-minimizing features that Canadian money provides. Anyone who holds, say, $100 U.S. dollars in their account cannot know ahead of time how much stuff they'll be able to buy over the ensuing three or four days. An equivalent C$100 provides near certainty. Lacking this nice property, Wells Fargo money faces significant headwinds at the outset.

This explains a point I was trying to make in my previous post on bitcoin. Bitcoin's battle to gain general acceptance will be a harder one to win than Wells Fargo's in Canada because the price of bitcoin is so much more volatile than U.S. dollars. Even if bitcoin's price eventually stabilizes so that it is just about as volatile as the U.S. dollar, it must still overcome the same unit-of-account hurdle as Wells Fargo i.e. neither can mimic the 'day planner' properties of the Canadian dollar. I don't think is an easy problem to overcome.



PS: Another complicating factor is product returns. If someone doesn't like the t-shirt they bought, and they paid in bitcoin, refunds are usually issued in U.S. dollars at the bitcoin-to-dollar conversion rates in play at the time of the transaction. So it's possible to make or lose bitcoin on refunds. For bitcoin owners, this adds an extra degree of uncertainty. Pay in dollars and you can be certain you'll get the exact same nominal amount back if the product is unsatisfactory. Pay in bitcoin and who knows what the amount of bitcoin you'll be refunded.

Friday, September 30, 2016

In praise of anonymous money



A while back I was paying for gas at a nearby gas station when the clerk fumbled my credit card. When he bent down to pick it up he momentarily disappeared behind the counter. Because credit card transactions are always such repetitive affairs, this slight break from routine raised my hackles. Might the clerk have done something with my card while out of sight, perhaps taken a quick photo of it?

Credit and debit payments require the relay of personal information. But this information-richness is also their weakness, since valuable data can be "skimmed" and used to attack the payer later on. That's why an anonymous payments medium is so important; it provides buyers with a shield from everyone else involved in a transaction. The next time I payed for gas at the nearby station, I bought myself some peace of mind by handing the clerk a few $20 notes instead.

Like banknotes, bitcoin is a (near) anonymous payments medium. My gas station doesn't accept bitcoin, however, nor would I be able to pay for a tank of gas with bitcoin since I'm wary of holding more than a few dollars of the volatile stuff. There is no inherent reason that an anonymous digital money must be volatile. David Chaum's eCash, first proposed in the 1990s, was a monetary product that, unlike bitcoin, offered stability while still allowing for anonymity.

Here's a broad-brush description of how eCash worked. A customer would kick the process off by creating $x worth of digital coins, each with a unique serial number. The bank would in turn sign the coins and debit the customer's bank account for that amount. Thanks to Chaum's invention of blind signatures, the bank would not be able to see the serial numbers of the coins it had signed, and thus could not match those coins to a specific person. This 'blinding' provided a measure of anonymity.

What about the double spending problem that bedevils digital cash? Because digital coins can be copied ad infinitum, a mechanism must be introduced to prevent a dishonest actor from buying up the entire world. Chaum solved this by having the bank rig up a database of already-spent coins. When the customer spent $x at a merchant, the merchant would call up the bank and provide it with each coin's unique serial number. The bank would check the number against its database to ensure that the coins had not been spent. If they hadn't, the transaction was free to proceed. The merchant in turn had to return the $x to the bank to be redeemed.

Bitcoin's creator(s) Satoshi Nakamoto doesn't seem to have been a fan of Chaum's eCash. In his famous white paper, Nakamoto says (not referring to eCash in particular) that the "problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank." Later on in a forum post Nakamoto talks about the "old Chaumian central mint stuff," noting that:
a lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990s. I hope it's obvious that it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we're trying a decentralized, non-trust-based system.
Nakamoto thus designed Bitcoin so that it had no central points of control. There is no third party database to record serial numbers; instead, the task of validating transactions is outsourced to a distributed network of anonymous miners and nodes. As for the money supply, there is no "Chaumian central mint" that issues and redeems tokens; rather, the evolution of bitcoin supply is set ahead of time by the Bitcoin protocol.

By sacrificing this last central point of control, Nakamoto condemned bitcoin to being a permanently volatile instrument. Unlike eCash, which is stable because the issuing bank pegs its price to that of bank deposits at a rate of 1:1, bitcoin's purchasing power is left entirely to the whims of market demand. Should market demand suddenly rise, bitcoin can double in price. Should it collapse, bitcoin will be worth $0.  

Sacrificing the Chaumian issuer/redeemer leads to another, more nuanced, trade-off; because bitcoin is not pegged to the dollar, retail prices will always be expressed in dollars with the bitcoin equivalent bobbing up and down every few seconds or so. Put differently, bitcoin users must get accustomed to the unit of account and medium of exchange being divorced from each other.

Contrast this to eCash. Thanks to the peg, the two functions of money—unit of account and medium of exchange—are married. Anyone who owns eCash can relax knowing that they possess the same exact unit that all other economic actors are using to express prices. This provides eCash users with a degree of certainty. As a service to their customers, retailers tend to keep prices sticky in terms of the unit of account for days, even months. So if carrots are going for $2 today, an eCash owner knows that they'll be going for that same amount next week. This fixity makes planning one's life a much easier affair. Those who own bitcoins enjoy no such certainty. Carrots that cost 0.005 bitcoins today may cost 0.01 next week.

So these two monetary products provide users with a degree of anonymity while asking them to make very different sacrifices. Bitcoin foregoes both stability and the convenient marriage of unit of account and medium of exchange. Chaum's eCash retains both stability and a marriage but introduces several central points of control that might render it subject to attack. Pick your poison. My gut feeling, however, is that over the long term, the public will prefer to stomach some degree of centralization in return for a stable anonymity product that doesn't suffer from medium of exchange/unit of account divergence. But I could be wrong.