The Feds Can't Put Down The Cash Pipe

Why are we still using cash? That’s the question that motivates the latest episode of Freakonomics Radio. Given the rapid advances we’ve enjoyed in digital payment technology thanks to debit and credit cards and apps like PayPal, Apple Pay, and Venmo, many economists are puzzled that cash hasn’t already begun going the way of the dodo. But what’s even more puzzling – and what the latest episode of Freakonomics delves into – is the fact that despite these major FinTech (financial technology) advances, there are actually more dollars floating around in circulation today in real terms than ever before.

Cash

What can possibly explain this phenomenon? Black Market activity.According to the Federal Reserve (Fed), in the mid-1970s, there was roughly $80 billion of U.S. currency floating around the global economy. By the mid-2000s, that number had skyrocketed by nearly 2,000 percent to nearly $1.5 trillion . Even more puzzling is the fact that there has also been a massive shift in the composition of the bills that comprise that total. In 1976, $100 bills – the largest denomination bill available – comprised less than 25 percent of the currency in circulation. Today, these large bills account for roughly 80 percent of the outstanding bills in circulation, a more than 300 percent rise since 1976.

What can possibly explain this phenomenon? There are obviously many factors that might contribute to why the public demands more nominal dollars. Most notably, inflation has caused the price level to rise by roughly 400 percent since 1976. The eroding value of the dollar has made large denomination notes like the $100 a more common medium for ordinary consumers. However, the increase in currency outstanding and large denomination notes has far outstripped inflation. To their credit, the two economists interviewed in the episode – Harvard’s Kenneth Rogoff and Yale’s James S. Henry – identify the primary factor: black market activity.

Why does the mafia-hired butcher (i.e. assassin), weed brownie baker, and crack pipe maker prefer Federal Reserve notes to debit cards, bitcoin, or gold? The economic rationale is straightforward. No payment medium is as widely accepted, easy to transport, and anonymous as cash. Put yourself in Walter White’s shoes from the hit AMC series Breaking Bad and you’ll realize that it’s far easier to ship crates full of $100s than entire boatloads full of small denomination notes to keep your international meth empire afloat. One of the most powerful pieces of evidence is that the vast majority of $100 bills in circulation today (roughly three-quarters, Henry estimates) reside in border cities that serve as drug trafficking hotspots such as Los Angeles, El Paso, and Miami.

The Battle between Public Welfare and Public Choice

One of the best ways to unearth this multi-billion dollar underground economy that has gained currency amongst scholars in recent years is to cut off its very lifeblood by reducing or even eliminating our reliance on cash.

Why aren’t the feds chomping at the bit to cut off the cash pipeline to the underground economy? The most sinister yet accurate explanation is the one offered by Rogoff: the feds and the Fed are hesitant to put down the cash pipe because they enjoy enormous fiscal benefits from being the preferred cash dealer of the global black market.

Black markets matter for central banks because they form such a large share of their potential customer base. According to research conducted by economists Ceyhun Elgin and Oguz Oztunali , the size of the black market globally is roughly 25 percent of world GDP, or roughly $28 trillion in 2014 dollars. Since the U.S. dollar remains the most trusted and recognized currency, it is the top choice for global criminal syndicates.

It is for this reason that Rogoff refers to the Federal Reserve’s implicit partnership with the criminal underground as “reverse money laundering.” The way black market participants behave also makes them ideal clients for central banks. Due to their keen desire not to be detected, they are less likely to quickly spend currency, putting it back into circulation. Even when some of it is laundered, the vast majority remains in the underground economy.

Why does this low velocity of cash (i.e. high demand to hold rather than spend cash) in the underground economy serve the interest of both the Fed and the feds? The theory of free banking provides some illuminating insights. In a free banking system, private banks profit whenever their customers decide to hold a larger proportion of money balances in the form of that bank’s notes and IOUs.

The reduced flow of its liabilities through the interbank clearing system frees them to invest in more interest-bearing loans and securities without experiencing adverse clearings. This may, in turn, allow the bank whose liabilities are in higher demand to earn more interest revenue and higher profits, which redounds to the benefit of its depositors in the form of higher interest paid on deposits and/or its shareholders in the form of higher dividends and share prices.

The feds and the Fed are hesitant to put down the cash pipe because they enjoy enormous fiscal benefits from being the preferred cash dealer of the global black market.Similarly, in a system where the government bestows a monopoly of note issue on a privileged bank, that central bank (i.e. the Fed) and its sponsor government reap enormous benefits when their primary customers (in this case, black market participants) elect to hold their currency as their preferred medium of exchange and store of value.

With a higher demand for its notes, the Fed is able to expand its balance sheet and buy more Treasuries than it otherwise would and still achieve its inflation target and other macroeconomic objectives. This also provides a lucrative source of revenue for the Treasury since the Fed is required by law to remit their profits (net of expenses such as central bank salaries, dividends paid to member banks, etc.) to the Treasury. In 2015 alone, the Fed remitted $120 billion to the Treasury . For politicians, this is an especially attractive revenue source because it lets them avoid the electoral blowback of raising taxes or increasing the national debt. As far as they’re concerned, it’s a free lunch.

Perhaps the most fascinating and revealing part of the Freakonomics episode came when Rogoff illustrated this by telling the story of the task force that former Treasury Secretary Robert Rubin organized in the late 1990s to discuss the issue of paper currency, citing Rogoff’s work on why the U.S. should reduce its reliance on cash.

But Rogoff was stunned to see Rubin’s primary motivation for organizing the task force was to discuss not how to reduce our reliance on cash, but whether the Fed should issue even more higher denomination notes to prevent the European Central Bank, which had just announced its intention to issue a 500 euro note, from cutting too heavily into the U.S. global currency market share. The primary beneficiaries of this policy, as Rogoff’s work showed, would be the very black market actors that the DEA, the Department of Justice, and so many other branches of the federal government were ostensibly trying to combat.

While the prospects of moving towards a “cash-lite” or cashless economy are less likely in the U.S. precisely because of the enormous fiscal advantages our status as the world reserve currency confers, countries that face a much smaller black market demand for cash have begun making the transition. This movement away from cash is largely a reflection of consumer preferences in the legal economy for digital money products.

Sweden is given as a prime example in the Freakonomics episode. Over the past five years, Sweden reduced its share of cash as part of the economy from roughly 6.5 percent to two percent . The swift transition came in part as a result of a national scare that followed a multi-billion dollar heist of Sweden’s largest cash manufacturing and storage depot in 2009 . The heist prompted public advocacy groups to go around convincing people to stop using cash and instead to rely on more secure (i.e. harder to physically steal) digital forms of money for their everyday transactions. But the move came in large part as a result of a shift in consumer preferences away from coins and currency and towards electronic payment cards and smartphone apps that was already underway.

Other economies like India and Sub-Saharan African countries that have experienced success with “mobile money” like Kenya and Tanzania are also quickly reducing their reliance on cash. Some of this comes as part of their financial inclusion agenda to make sure every citizen has access to digital payment services, since reliance on cash is considered an obstacle to financial inclusion. In most of these countries, cash is now considered a nuisance to hold and use in transactions.

To some degree, this transition is also occurring in the licit sectors of the U.S. economy, where digital payments are increasingly replacing currency as the primary payment media. Were many of the items the U.S. government currently prohibits made legal, it’s very likely this trend would lead to a general fall in the demand for cash. But so long as the feds maintain their international drug war and other policies that contribute to the enormous size of the global black market, the greenback isn’t going anywhere.

More (Private) Money, Less Problems

Getting government out of the currency business could expedite the transition to a cashless economy.Although most economists don’t acknowledge it, there’s actually a much easier way for governments to remedy this cash conundrum that doesn’t involve ending the drug war overnight (arguably the best solution) or prying cold, hard cash out of the cold, dead hands of its citizens: they could simply remove the monopoly on paper currency that they’ve bestowed on central banks and allow competing banks to supply their own notes.

The idea of allowing private banks to issue currency might seem radical. Luckily, there have been many successful precedents in history. Banks in historical free banking systems, such as 18 th and early 19 th century Scotland and 19 th to early 20 th century Canada, devised much better, more secure forms of circulating media in order to satisfy their customers’ demands.

Due to the intense competition between rival banks, the security features on these notes to detect counterfeiting and unusual or illicit activity were often vastly superior to central bank-issued money. The efficiency of the interbank clearing market also proved to be an effective way of preventing unwanted or counterfeit notes from circulating for long. These features help explain why the Scottish and Canadian systems were the marvel of the financial world.

Getting government out of the currency business could actually expedite the transition to a cashless economy. If banks were free to issue liabilities in whatever form their customers demanded, the only real demand for Federal Reserve notes would be to serve as bank reserves and to settle interbank clearing imbalances. In theory, even these reserves could be digitized. This trend is already occurring. One small step towards privatizing currency could therefore lead to one giant leap towards a cashless economy.

The (Silk) Road Forward: Is It Time to Make Some Change?

Even if policymakers acknowledge the superiority of private currency, there are billions of reasons why they might not want to relinquish their monopoly without a fight. One of the challenges economists have to overcome, then, is shifting the intellectual debate towards being more willing to permit financial innovation, and competition in money.

Why shouldn’t we permit more competition and choice in currency like we do with transportation and education?This battle can to some degree be fought in academia and policy circles. But arguably the best approach would be to turn the tide of public opinion. Thanks to popular business models like FedEx, UPS, Uber, Lyft, AirBnB, and things like online education and charter schools, we finally have a way to frame this debate in a way that the average person can understand and support: expanding choice . Why shouldn’t we permit more competition and more choice in currency in the same way that we now allow more consumer choice in mail delivery, transportation and lodging services, and education? Competition might not be welcomed by existing monopolies, but it’s great for consumers.

Ultimately, the primary motivation for moving away from paper currency shouldn’t be to eliminate voluntary transactions in the black market or reduce tax evasion. It should be to satisfy consumers’ demands. And that is a task that is far better left to the invisible hand.

Scott Burns