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Summary

Fractional reserve banking is based on the illusion that our money in our transaction account in the bank is always intact and available. With fractional banking, demand deposits are fractional money, as demonstrated terrifyingly by the Great Depression. Fractional reserve banking has been kept on artificial life support by deposit insurance schemes. What electronic money institutions offer is not safe money, but just another version of debit cards. Digital money issued by new payment providers shares the traits of bank money, meaning it is fractional digital money. As transaction accounts make up a relatively small proportion of all deposits, and an even smaller part of broad money (M4 in the UK, or M3 in the ECB system), their de-fractionalisation would not pose a monetary problem, but is not possible without political support.

Key words: fractional bank money, money illusion, deposit insurance, full reserve banking, electronic money institutions, fractional digital money.

A double illusion

Fractional-reserve banking is based on the illusion that our money in our transaction account in the bank is always intact and available. This may make us think that the sum of balances in all transaction accounts is equal to the bank’s reserve. But it isn’t. The bank knows that owners of transaction accounts or demand deposits will never ask to draw their money all at the same time, which allows it to execute our payment orders using reserves smaller by a factor of ten or 15. The ratio between the bank’s reserves and our deposits is called the reserve-deposit ratio, and commercial banks’ deposit-taking business is termed fractional reserve banking.

If we ever doubt the ability of our bank to repay us our money – say, because it looks like it’s having issues with liquidity, such as Northern Rock did – we can either rush to join the queue to take the money out, or else rely on the government’s deposit insurance. Because of cash withdrawal limits, one urgent action is to transfer the money to another bank that we believe is safer. Technology again comes to the rescue – in this age of e-banking, there’s no need to queue outside banks. All you require is one online payment order, provided you’ve got an account with a different bank; also, obviously, your old bank has to be able to honour it. The time of the old-fashioned run on the bank has passed, with physical panic now replaced by e-panic.

Consequently, our non-cash money, which we can dispose of only using the bank as an intermediary, is best termed fractional bank money. The extent of the illusion is revealed by just how fractional this money is, as measured by the reserve-deposit ratio. With negative interest rates recently extended to demand deposits (transaction accounts), especially those with balances exceeding a minimum threshold (see Negative Nominal Interest Rates), we’re in thrall to a double illusion: the banks are charging us for ‘safekeeping’ money they’ve already mainly invested elsewhere. This is a veritable alchemical process, but no court has yet weighed in with a decision.

Fractionality, the ultimate banking illusion, has endured for centuries in spite of countless banks going bankrupt and their clients losing their deposits. Admittedly, it has benefited from lender of last resort arrangements and governments’ deposit insurance schemes. Many see fractional banking as the foundation of modern banking, and with good reason. Some historical background to this illusion will help us understand what makes our money in the bank safe, and how this mechanism is connected with the latest trends in the modernisation of payments and money issuance.

The origin of fractionality

Deposits were a natural extension of money changing operations in Mediaeval Europe, which banking evolved from and where banks got their name (banco is Old Italian for ‘bench’, as these early currency dealers traded on benches improvised as desks; ‘bankrupt’ comes from banco rotta, literally ‘broken bench’). Early deposit banks were universal banks, which provided a wide range of services but also went bankrupt frequently, a common occurrence in fractional banking. Venice was among the first nations to face deposit failure: ‘The basic problem with the Venetian payment system based on private banks was the possibility of failure. … Deposit banking and commercial banking were not separate, and bankers extended loans or invested directly’.[1] With nearly 100 banks having failed by the 1550s, Venice set up the public Banco di Rialto, which was ‘essentially a government intervention to correct a market failure: the institution created was intended to supply a payment service hitherto provided by the private sector, but in a manner found to be wanting.’[2] The Banco di Rialto was soon replaced by the Banco del Giro, which would serve as the model for many public banks throughout Europe. It’s now obvious that fractional banking has been causing the same problems for hundreds of years, but 16th century Venice was yet to discover the principles of lender of last resort and deposit insurance scheme.

Public banks proliferated during the 17th century as cities and countries sought to safeguard deposits and provide secure payments systems, so that ‘the idea of public banks was virtually synonymous with the idea of a giro bank operating in a republic (Genoa, Venice, Amsterdam, and Hamburg).’[3] The development of these banks in Continental European practice reflected an aversion to private depositaries, due to a wealth of adverse experiences.

The most famous public bank, based on deposit security, or full reserve banking, was established in 1609 as the Amsterdamse Wisselbank, better known as the Bank of Amsterdam (BoA). By pioneering non-cash payments via a giro system of net clearing, in an environment flooded by poor-quality coin produced by innumerable mints, the BoA revolutionised money. ‘Merchants from all over Europe were then content to leave their specie and precious metals in the vaults of the bank. (Even John Law, the great financier for France from 1715 to 1720, kept his personal account open, if inactive, and with a minimum deposit, after he left Amsterdam)’.[4] Six decades later, it was another Scotsman, Adam Smith, who called the money issued by the BoA bank money, emphasising its intrinsic superiority to currency, security, simplicity and risk-free transfer.[5]

The absolute monarchies of the day evidently did not favour public banks, probably fearing they would jeopardise the sovereign’s monopoly on minting money. Deposits were particularly under threat in England in the 17th century, a time when the erratic rule of the first Stuarts was followed by the Civil War, then the Restoration, and, finally, the Glorious Revolution. This, the most turbulent time in English history, saw the emergence of a new set of deposit-takers: the goldsmiths of London. To them we owe some exceptional monetary innovations, such as ‘goldsmiths’ notes’ (which later evolved into banknotes), and fractional reserve deposits transferrable by cheque. These new devices blazed a trail for modern banking, with all its strengths, weaknesses, and risks.

Confused about deposits

These new practices created a fundamental problem that hasn’t been resolved to this day: the lack of a distinction between money on account or demand deposits and time deposits, i.e. non-cash money vs financial investment. These were clearly differentiated only in the early 1900s, but even as late as after World War I some British and American banks still allowed clients to draw cheques on savings deposits. To this day, most economists use the collective noun ‘deposits’, although most central banks have long since given up trying to clearly define deposits that constitute money. ‘Just which kinds of deposit obligations count as “money” depends on definitions, of which there are several, all somewhat arbitrary.’[6] The combination of fractional reserve banking and confusion about deposits has caused numberless runs on banks, bankruptcies, and banking crises.

The fractionality of bank reserves therefore became the main hallmark and driver of English banking from the time of the first industrial revolution. The key word here is promise: banks promise to pay a sum to the bearer on demand, using fractional reserves they hold as assets. The use of cheques completely transformed the non-cash business previously developed by public banks. ‘The increased use of cheques is a striking feature of London private banking in the latter half of the eighteenth century’.[7] All evidence suggests that deposit banking based on fractional reserves was flourishing as early as the 18th century, with payments made through the system far outstripping those in actual cash. Yet it failed to attract much attention, since non-cash payment instruments ‘circulat[ed] chiefly among the trading world [and came] little under the observation of the public.’ (Henry Thornton, Paper Credit).

The different treatment of cash and non-cash money, or banknotes as a regulated business and bank deposits as a free market activity, was first legislated in the UK’s Bank Charter Act 1844. The intention was to split the Bank of England’s note issuing operations from its general banking business by creating distinct Issue and Banking Departments. The Act therefore separated central bank money for the public (Issue Department) from central bank deposit money, available only to banks (Banking Department). So, the general public, forever denied access to risk-free central bank deposits for transactions, was forced to use fractional bank deposits for non-cash payments, although before the Act was passed the Bank used to accept individual deposits. ‘Other banks, although stripped of the right of issue, were virtually unmolested in the creation of deposit currency.’[8]

The fact that banknotes earned no interest, whereas demand deposits were interest-bearing, helped assuage deposit-holders’ aversion to risk. The convenience of account-to-account payments by cheque made demand deposits doubly attractive, in spite of their fractional nature. This quality made economists start calling them bank money, neglecting their promissory character. Adam Smith was among the first to use this term, although he employed it to refer to the full reserve deposits the Bank of Amsterdam utilised for non-cash risk-free transfers. In fractional banking, demand deposits are fractional money, as demonstrated terrifyingly by the Great Depression.

The destruction of our demand deposits

‘The most outstanding fact of the last depression is the destruction of eight billion dollars – over a third – of our “check-book money” – demand deposits.’[9] The author of this quote, Irving Fisher, was a renowned economist who lived through this cataclysm and employed mathematics to expose the real interest rate. His sketch of the destruction of the dollar illustrated the scale of the money illusion, or just how fractional transaction accounts in banks in really were. It wasn’t eight billion dollars in non-cash money that were destroyed, it was eight billion dollars in claims on banks. Depositors’ money had already been invested, either in securities or as bank loans, which the economic crisis made uncollectable. Nine thousand US banks failed during the Great Depression, a third of the entire banking sector; 4,000 banks went bankrupt in 1933 alone. The greatest series of bank failures in history is slowly being forgotten, just like the terrible Spanish Flu of not-so-distant 1918. The Covid-19 pandemic has been a forceful reminder that not all contagious diseases have been eradicated – including a possible new banking contagion.

As Irving Fisher succinctly put it, the dollar grows scarcer ‘by reason of the destruction of the check-book money of the nation through the liquidation of bank loans; and finally, the fundamental reason why such liquidation destroys our check-book money lies in our partial reserve system.’[10] This is why he and a group of colleagues proposed ‘the 100% money plan’, which would require 100% reserve for deposits, so making them perfectly safe.[11] This suggestion, also known as the Chicago Plan, continues to attract the attention of many economists.[12]

Unsurprisingly, Fisher didn’t invoke London banking practice, but the Bank of Amsterdam. The powers that be rejected his plan on the pretext that it would destroy banks’ deposit business (even though it would have applied to only a small portion of these affairs, demand deposits or transaction accounts). So failed the last attempt to separate monetary and credit operations, tried for the first time in 14th century Venice.

Fractional reserve banking has been kept on artificial life support by deposit insurance schemes, formalised with the creation of the world’s first institution of this type, the US Federal Deposit Insurance Corporation (FDIC). The FDIC’s crest reads ‘1933’ as a symbol of victory over the Great Depression, even though the Corporation began operating only a year later.

Additional support to the faltering bank sector was to be provided by the Federal Reserve System, or the Fed, as the lender of last resort, a function it did not perform in the Great Depression.

Milton Friedman, the founder of monetarism, fiercest critic of the Fed, and champion of the free market, distrusted these solutions to problems of fractional reserve deposits and promissory money. As early as 1959, in his famous A Program for Monetary Stability, Friedman set out a list of the ‘good reasons’ why ‘monetary arrangements have seldom been left to the market’, which he kept the same until the latter half of the 1980s. A major ‘good reason’ is ‘the peculiar difficulty of enforcing contracts involving promises to pay that serve as a medium of exchange and of preventing fraud in respect of them. … However, the character of the difficulty has changed. … Moreover, it is now taken for granted that governments (i.e., taxpayers) will completely shield holders of deposit liabilities from loss’.[13] The lines of deposit-holders queuing outside Northern Rock branches in 2008 were tangible proof of Friedman’s visionary thoughts about deposit liabilities.

James Tobin put it slightly differently: ‘It is, after all, historical accident that supplies of transactions media in modern economies came to be byproducts of banking business and vulnerable to its risks.’ (Financial intermediaries, p. 26).

Contemporary bank deposit money

Confusion about bank deposits persists, especially in the UK, as confirmed beyond doubt by the standard reference handbook published in 2000 by the Bank of England: ‘Money intended primarily for use in transactions … has been hard to define satisfactorily in the UK. This is because there is no administrative distinction, or any clear commercial distinction, between deposits held for transactions and those held as wealth.’[14]

By contrast, the Fed draws a clear ‘regulatory distinction in Regulation D between reservable “transaction accounts” and non reservable “savings deposits”’, as highlighted in the very terminology used, accounts vs deposits. Urgent temporary measures in response to the ‘novel coronavirus situation’ do not alter this distinction in any meaningful way but do reveal how far the Fed is ready to go to address the Covid-19 recession.[15]

Nevertheless, reservable ‘transaction accounts’ remain fractional bank money, inferior to central bank money, which is comprised of ‘safe forms of money, with no chance of default.’[16] This is why our money in banks will continue to remain the only security that is only fractionally safe. All other securities, both debt and equity, are protected by custody banking. Why is it, then, that there’s no custody banking for our money as well?

Wrong exit

Electronic money for the public offered a possible solution to the fractionality issue. According to the definition used by the European Central Bank (ECB), electronic money (or ‘e-money’) is ‘an electronic store of monetary value on a technical device’, where ‘the device acts as a prepaid bearer instrument which does not necessarily involve bank accounts in transactions.’

Central bankers, however, were afraid that direct access to electronic central bank money by the public (obviously, banks had access to it from the very beginning) would cause flight of demand deposits from commercial banks. A way out was found in the EU Directive 2009/110/EC on the supervision of the business of electronic money institutions, which are legal persons ‘granted authorisation to issue e-money’ (ECB). Article 2(1) of the Directive broadens the definition of electronic money to mean ‘electronically, including magnetically, stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions.[17] So our money is now a claim not only on banks, but also on these new payment service institutions. Clearly, what we’ve got here is not safe money, it’s just another form of debit card.

Exit

Given that transaction accounts make up a relatively small proportion of all deposits, and an even smaller part of broad money (M4 in the UK, or M3 in the ECB system), their de-fractionalisation would not pose a monetary problem, but is not possible without political support. Banks are an inevitable payment intermediary, so that safe transaction accounts would have a positive effect on the stability of their business and improve their less than stellar perception in public. Incidentally, the extreme protection commercial banks get from governments and their agencies, especially central banks, has made the banking sector vulnerable and sluggish to modernise its business models. It may be paradoxical, but it’s quite likely that banknotes will outlive traditional commercial banks, battered as they are mercilessly by their technologically hyper-innovative competitors. Instead of fractional bank money, what we’d get is fractional digital money.

Until this happens, all we can do is try to keep our transaction accounts safe in banks with fractional reserves. Government deposit insurance has its limits, not just in the amounts it covers, but also in terms of their aggregate volume. This is why it’s good, from time to time, to check up on our money the old-fashioned way: by converting into banknotes some of the non-cash money in our bank accounts.

MAKE SURE YOUR TRANSACTION ACCOUNTS REMAIN CONVERTIBLE

KEEP YOUR MONEY IN YOUR HANDS

[1] William Roberds and Francois Velde (2014), Early Public Banks, Working Paper 2014-03, FRB of Chicago, July 2014 (Revised), p. 15-16.

[2] Ibid.

[3] Ibid, p. 4.

[4] Larry Neal (2000), How it all began: the monetary and financial architecture of Europe during the first global capital markets, 1648-1815, Financial History Review, No. 7, p. 121.

[5] ‘Bank money, over and above both its intrinsic superiority to currency, and the additional value which this demand necessarily gives it, has likewise some other advantages. It is secure from fire, robbery, and other accidents; the city of Amsterdam is bound for it; it can be paid away by a simple transfer, without the trouble of counting, or the risk of transporting it from one place to another.’ Adam Smith (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, New York: The Modern Library, 1937.

[6] James Tobin (1987), Financial intermediaries, Cowles Foundation Discussion Paper No. 817, p. 5.

[7] R.D. Richards (1958), The Early History of Banking in England, Routledge, 2012, p. 192.

[8] Frank Whitson Fetter (1965), Development of British Monetary Orthodoxy, 1797-1875, Harvard University Press, p. VII.

[9] Irving Fisher (1936), 100 % Money and the Public Debt, Economic Forum, Spring Number, p. 420.

[10] Ibid, p. 421.

[11] ‘One hundred percent reserve deposits would, of course, be perfectly safe – that is, as safe as the national currency – and would not have to be insured. Those deposits would in effect be currency, but in a secure and conveniently checkable form. One can imagine a system in which banks and other financial intermediaries offered such accounts, with the reserves behind them segregated from those related to the other business of the institutions. That other business would include receiving deposits which required fractional or zero reserves and were insured only partially, if at all.’ Tobin (1987), p. 25.

[12] Jaromir Benes and Michael Kumhof (2012), The Chicago Plan Revisited, IMF WP 12/202.

[13] Milton Friedman and Anna Schwartz (1987), Has Government Any Role in Money?, In: Anna Schwartz (ed.) (1987), Money in Historical Perspective, University of Chicago Press, p. 291-2, 310.

[14] John Thorp & Philip Turnbull (2000), Banking & Monetary Statistics, Centre for Central Banking Studies, Bank of England, December 2000, p. 6.

[15] Federal Reserve Board – Regulation D – Savings Deposits, FAQ, Last Update: April 24, 2020.

[16] Wataru Takahashi (ed.) (2012), Functions and Operations of the Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, p. 3.

[17] Directive 2009/110/EC of the European Parliament and Council of 16 September 2009.

Summary

The squeezing-out of cash means, in essence, the elimination of government money for the public. We know that this process has been going on since the 18th century and could not be reversed even by the gold standard, which applied only to central bank notes. It was not the ‘War on Cash’ that dealt cash the final blow: it was merchants’ refusal to accept national currencies in banknotes and coins. In a cashless society, only private money exists. The fundamental problem is that the disappearance of central bank notes means the end of risk-free money for the public, the only money with a stable nominal value. Without banknotes, £10 will not always be £10, €10 will not always remain €10, nor will $10 always stay $10. The end of cash will remove the final line of defence against monetary policy without constraint and corporate money issuers.

Key words: cash, banknotes, government money, private money, the course of cash, war on cash, legal tender status, payment tigers.

The gradual expulsion of government money

Coins are government money and so is, ultimately, central bank money. Since non-cash central bank money is not available to the general public, government money for the public is comprised of coins and central bank notes, in other words, of cash. So the expulsion of cash is, essentially, the abolition of government money.[1]

We know that this process has been going on since the 1750s, when the bankers of London concluded that issuing banknotes was not as profitable as doing business with non-cash money on account. This initial squeeze-out of cash was not halted by the introduction of large-denomination banknotes (the minimum being £10), which were readily used by businesspeople and the wealthy. Simply, non-cash money on account proved superior for wholesale payments. The lowering of banknote denominations throughout the 19th century did not slow the process down but merely meant increasingly fewer coins were used for daily retail payments.

In a seeming paradox, the ousting of cash could not be stopped even by the gold standard, which applied to central bank notes of most countries in Europe and further afield but not to households’ and firms’ deposits with commercial banks. Moreover, before the 1930s, the convertibility of bank deposits into banknotes was not assured by the government, but depended on the liquidity and solvency of the saver’s bank. The explanation for this lies in the efficiency of account-to-account wholesale payments and interest returns on deposits.

The final exodus

The final exodus of cash from retail payments, its last stronghold, began with the introduction of payment (credit and debit) cards, followed by ATMs and PoS terminals. Understandably, the innovations were broadly accepted by most money holders: they facilitated payment services, and money in banks was convertible into banknotes at face value.

Over the past decade, contactless payments by card and smartphone have meant cash has increasingly been ‘out’, with its legal tender status reduced to nothing but a myth. The cashless economy ignores central bank notes, or government money. ‘When people come across a cashless café, restaurant or pub for the first time they can be surprised that they don’t have a right to use cash in the UK, and that cash acceptance is determined by the party offering the service.’[2] It would be interesting to see whether the UK Government and the Bank of England would react if the party offering the service in London posted a note announcing it only accepted euros, bitcoins, or libras. New York and many other cities throughout the world are facing the same issue. Stockholm has taken this absurdity to new heights: there, krona notes are not accepted by nearly anyone, except the Riksbank, and, perforce, hospitals (see How Money Disappears).

Central banks will continue to supply cash until the last café, restaurant or pub stop accepting it. Faced with the threat of the Covid-19 pandemic, most countries’ national banks re-affirmed this position, with the Bank of England being one of the first to do so: ‘The provision of secure physical cash is a core part of our mission. The Bank has made clear its commitment to continuing to produce cash for as long as people want to use it. … Acceptability requires not just that banks distribute and “bank” cash. It also requires that merchants accept it.’[3] Only days earlier, on 19 February 2020, BBC News reported that the UK’s cash system ‘will collapse without new laws’.

So, it turns out, acceptance of a nation’s currency in banknotes and coins depends not on their legal tender status, the government, or the central bank, but on merchants and their payment policies. The US has nearly identical rules in place: ‘Private businesses are free to develop their own policies on whether or not to accept cash unless there is a state law which says otherwise.’[4]

With the global exodus of cash from payment systems and economies in full force, cash was put on two symbolic trials, one in 2015 in Zurich and another in 2019 in Frankfurt. The principal organiser was SUERF, the European Money and Finance Forum, seemingly guided by the honourable intention of provocatively presenting and thoroughly discussing issues that are set to determine the fate of cash. Given the arguments for and against, as advanced by witnesses for the prosecution and witnesses for the defence, and the turbulent events that took place between 2015 and 2019, it will be useful to look at the conclusions of these two events.

Cash on trial

The first conference, held in November 2015, saw simultaneous presentation of both indictments against and evidence in favour of cash. ‘Cash has been accused of three sins: First, cash is inefficient and costly to use and society would be better off without it. Second, it promotes crime, and facilitates money laundering and tax evasion. Third, it makes negative nominal interest rates infeasible.’[5]

One of the main arguments in defence of cash was that it was fast and easy to use. Also highlighted were its privacy, anonymity, role in preventing central banks’ extreme interest rates, the fact that the state earns income from seigneurage, and so on. The defence focused on rebutting specific accusations, but other benefits of cash were advanced as well. ‘Cash provides an insurance against very bad outcomes, such as economic crises, hyperinflation, or the failure of computer or electricity networks. The costs of cash can therefore be viewed as an insurance premium.’[6]

The Cash on Trial conference, which took place in May 2019, recorded fewer accusations against cash, with its inefficiency in payment being the most serious one. The principal indictments are condensed in the title of a speech made by one of the witnesses for the prosecution: ‘Cash – an inefficient and outdated means of payment’.[7] The evidence and arguments in favour of cash once again prevailed over the accusations, even when it came to crime and terrorism.[8] It was especially emphasised that the tangible nature of cash contributes to the liberty and autonomy of members of society, allowing them to live off the grid.[9]

Between the two conferences, Kenneth Rogoff published his The Curse of Cash, with the gruesome title matched by equally gruesome content. The weight of the accusations laid at the feet of banknotes (the author is a supporter of coins, provided they are made of gold) requires a detailed look, before we move on to the war on cash, of which Rogoff is an enthusiastic supporter and proponent.

The Curse of Cash

The author contradicts himself from the very outset. He admits to having devoted an entire book to a ‘sideshow’: ‘Indeed, most academic and policy academics tend to think of physical paper currency as an irrelevant sideshow in today’s world of high-tech banking and finance.’ (Preface) The titles of the three sections reveal his preferences and intentions: Part 1, The Dark Side of Paper Currency; Part II, Negative Interest Rates; and Part III, International Dimensions and Digital Currencies.

On the first page of The Dark Side, having referenced Goethe’s Faust, Rogoff rolls out an outrageous charge: ‘Goethe, writing early in the nineteenth century, was nothing if not prescient. Without paper money, there might have been no German hyperinflation, and perhaps no World War II’.[10] Goethe indeed knew of the collapse of John Law’s bubble, and read Adam Smith and even Henry Thornton (he even revised the German edition of Thornton’s Paper Credit),[11] but could not have been so far-sighted as to envisage a global conflict caused by the hyperinflation of banknotes, which Rogoff disparagingly calls paper money. On the contrary, it was banknotes that allowed Germany to burn off the greatest part of its World War I reparations in the fire of hyperinflation while its citizens rejected the Reichsbank’s worthless paper. Goethe was ultimately unable to convince his fellow Germans that cash was cursed, and they continue to rank amongst the world’s greatest adherents of banknotes. Finally, associating World War II with banknotes is mockery of this most tragic event in human history.

Rogoff illustrates the unreliability of coins, the oldest form of cash, by citing their debasement during the decline of the Roman Empire. ‘In Rome, coin debasement produced cumulative inflation of 19,900% over the period 151-301 AD, a period that saw major revolts and plague’ (p. 19). Over these 150 years, this seemingly terrifying rate of inflation works out at no more than 3.6% annually, an unattainable goal from the 1960s to the 1990s for many developed countries, the UK and US included. The effects of plague are now plainly visible from our own perspective, tinged as it is by Covid-19. Rogoff has thus slandered ancient Rome’s monetary policy unprovoked. The table showing Selected peak debasement years for European coinage, 1300-1812 (p. 20) is similarly erroneous, as the peaks indicate cumulative debasement over the course of decades. Reducing the values to average annual growth rates would have revealed the true pace of coinage debasement.

Even though he considers it cursed, Rogoff does not dispute the importance of ‘paper money’ for his own nation’s independence: ‘Paper currency also played a major role in the American War of Independence from 1775 to 1783, financing the vast majority of the colonists’ expenditures.’ (p. 27). It is questionable whether the colonists saw the ‘paper’ as money or as war bonds, but the author would have to admit that no other means of issuing money would have given as much help to his ancestors in gaining liberty.

After thoroughly enlarging on all the evils and disasters caused by ‘paper money’, Rogoff proposes a most cunning Plan for Phasing Out Most Paper Currency. His proposal is based on three guiding principles: first, make it more difficult to engage in anonymous untraceable transactions; second, the speed of transition needs to be slow; and, third, that poor and unbanked individuals have access to free basic debit-accounts and possibly also basic smartphones.[12] The key oversight of his concept of a total banked regime is the likely disobedience of these poor and unbanked individuals, who may refuse to take up the free basic debit-accounts and basic smartphones. Perhaps this promoter of social engineering worthy of any totalitarian regime ought to think about obligatory basic microchip implants for the poor and unbanked individuals.

To date, the proposals Rogoff suggests for phasing out most paper currency have not helped bring about his desired banishment of cash, unlike the fluidity of legal tender status banknotes, which the author fails to recognise as an option for swift de-cashing.

The rapid phasing out of cash from most of the world in the latter half of the 2010s nevertheless proved too slow for the interests of the banking sector and many non-bank companies and institutions. Financial inclusion for all (see G-20 – High-level Principles of Digital Financial Inclusion, September 2016) and a cashless society were the rallying cries for both governments and the payment industry. Analysts at Germany’s largest bank concur: ‘Governments, banks and card providers share at least a goal: the elimination of cash’.[13] This is why a global war on cash had to be declared.

War on cash

A relatively comprehensive definition of this conflict and its objectives was given by Lawrence White: ‘[t]he “war on cash” refers to a set of policies, in the United States and around the world, deploying the power of government agencies to suppress the use of paper currency. The principal aim is to shift transactions to credit card and bank account media that leave an electronic data trail for law enforcement and tax authorities. A secondary aim is to raise the cost of cash storage so as to allow the central bank to push nominal interest rates further below zero’.[14]

Government agencies include the Fed, the Treasury Department, FDIC, and other public authorities whose decisions directly or indirectly affect the use of cash, here US dollar notes and coins. Similar government agencies are also employed in most other countries to eliminate cash. Yet the government is not the only stakeholder mobilised to combat cash. The ‘war effort’ receives robust support from banks and other financial institutions, as well as consulting firms, universities, research institutes, social media networks, non-profit foundations, and a host of other related entities.

Ensuring a means of payment that leaves an electronic data trail for law enforcement and tax authorities is a key focus of the conflict, yet not its primary goal. The primary and ultimate outcome is to abolish government money and transfer money issuing power from the public to the private sector. This makes banknotes only a tactical target, with central bank reserves remaining the strategic objective. The public have never fully understood the nature of these reserves, making them much easier to take over under the veil of a public-private partnership. Obviously, before this can happen, banknotes and coins must be abolished as evidence of erstwhile issuing power. Cash is here only collateral damage, and the private sector may reissue it at some point in the future in the guise of digital notes and coins.

Many central banks are in favour of the abolition of their own products, citing their technological obsolescence – an issue they hardly gave any thought to until recently. This is probably the only recorded case in economic history of a monopolist advocating the removal of its monopoly to the benefit of a technologically more advanced competitor. Perhaps absurdly, cash is being defended from central bankers by supporters of free banking, currency competition and new private monies. One of the most courageous of these cash defenders is Kevin Dowd:

‘One of the most significant developments in economic policy in recent years has been a gradually escalating government war against cash. … The abolition of cash threatens to destroy what is left of our privacy and our freedom … Quite simply, the government’s war against cash is the state’s war against us. Andy Haldane, the chief economist of the Bank of England – announced that he too was in favour of abolishing cash.’[15]

Policy tactics involve various restrictions and monitoring requirements that hinder the holding of cash, suppress cash transactions, and generally make cash more expensive to use.[16] However, none of these tactics is as effective at squeezing cash out as the ephemeral nature of cash’s legal tender status. Merchants’ freedom to set their own payment policies, as described above, has been accelerating the disappearance of banknotes and coins.

How the war can end

At the war’s end, the merchants will lead us into a cashless society. The Swedish central bank has an answer as to what that society will look like: ‘In a cashless society, a restricted group of financial corporations has access to risk-free central bank money. The general public, in contrast, does not.’[17] By being denied to the public, central bank money would lose its risk-free status, whereas reserves would remain private bank money. Soon after, a public-private venture would take over the issue of reserves, which would then comprise all of base money (without cash). Global payment corporations, encouraged by the full control they already exercise over payment systems, have no reason to refrain from reaching after the power to issue money. Monetary sovereignty, lost in the intricate interpretations of legal tender status, would be replaced by the sovereignty of the corporate issuers of reserves, i.e. of money.

Public-private issue of reserves will serve as an overture to the abolition of central banks and the fully private issuance of base money. The government would retain its deposit insurance function that employs taxpayer (our) money, whereas regulation and oversight would be the remit of independent agencies created from remnants of the former central bank. ‘In a cashless society, a financial crisis could arise in a situation where only private money exists’ (Riksbank, Petition, p. 8). The function of lender of last resort would have to be assumed by the new money issue masters, as it is inseparable from issuing authority, but is nonetheless difficult to reconcile with their private interests.

The incompatibility between the power of issue and private interests of corporate money issuers ultimately limits the feasibility of this new monetary order sketched out in the preceding paragraphs. The pretenders to the sovereign right to issue money are the same private banks whose business policies have caused so many financial and economic crises. The transformation of banks and payment providers from payment intermediators to money issuers will not do away with their genetic vulnerability. By definition, a money issuer cannot be illiquid, but it may still devalue its own product. No formal definition of a unit of account by the government will allay this danger, and corporate money issuance will inevitably lead to monetary chaos.

The new monetary order of the cashless economy hides a built-in construction error: the abolition of cash, which guarantees the stable nominal value of money. The absence of stable nominal value removes two of money’s fundamental functions, unit of account and measure of value. This structural weakness will bring the planned monetary system crashing down soon after central bank money for the public is scrapped. The abolition of cash will ultimately prove to be a Pyrrhic victory for the cashless armada.

Loss of anchor

Banknotes are the nominal anchor of the economy due to their stability of denomination, meaning that their denominated face value does not change. They anchor the nominal prices of goods and assets and relative price ratios, which is a precondition for the operation of product and financial markets. The nominal certainty of factor incomes (salaries, profits, rents, interest payments, dividends) underlies all our decisions to produce, sell, consume, save, lend, borrow, and invest. Without banknotes to serve as their anchor, the certainty of nominal values in the economy will inevitably be lost.

Their unchanging nominal value and transferability lend banknotes another unique characteristic: they discipline banks and other financial intermediaries, including the very central banks that issue them. Of all the forms of money, banknotes are the easiest to withdraw and dispose of, which sends a clear signal to their issuers and depositaries about how much we trust them. In a cashless economy, we would not be able to take out our money from the bank – all we could do is move to a different bank.

Immediate settlement is another characteristic of banknotes that sets them apart from other means of payment, which cannot function without payment providers. ‘A banknote is the payment instrument by which the highest settlement finality can be achieved’.[18] This highest settlement finality is clearly the reason why, according to Milton Friedman and Anna Schwartz, ‘there is no pressure by banks or other groups to gain that privilege’.[19]

Apart from all the advantages cited above, which are derived from the intrinsic nature of banknotes and the credibility of their central bank issuers, other prerequisites exist that have long been completely ignored. Conclusions of the Swedish Committee of Inquiry of 1881 can serve as a reminder: ‘The inquiry’s three main reasons for a banknote monopoly were: 1) banknotes should be entirely free of risk, 2) banknotes must be issued without a short-term profit motive, and 3) revenues from the issue of banknotes are necessary to fund a central bank’s function in society so that it does not have to act according to a profit motive.’ (Riksbank, Petition, p. 9). These past findings clearly indicate that what makes banknotes unique is their absence of a short-term profit motive and private profit from their issue, or seigniorage.

The re-introduction of the gold standard, which not even Kenneth Rogoff believes to be far-fetched, is also impossible without banknotes. Banknotes were the only form of money that allowed the gold standard to operate. Gold coins and gold certificates are not viable in practice as means of payment.

There is no reason to invoke the costs of payment in the retail sector as an argument against cash, as data indicate it is competitive in comparison with other means of payment. [20] Of course, if it continues to be squeezed out of everyday transactions, cash will lose its cost competitiveness.

In spite of all their exceptional qualities, banknotes are disappearing, and their passing marks the end not only of physical central bank money, but also of risk-free government money for the public. Its technological development neglected by its issuers, no longer accepted as legal tender, lacking an heir in the form of central bank digital notes, this authentic money has no chance of survival in the payment market. And so the precious heritage of Sir Robert Peel will be irrevocably lost in today’s world in which the banishment of cash has become a sign of progress, and where those the furthest advanced on that road are held up as paragons. ‘An emerging group of “payment tigers” have also made especially rapid progress – Poland, Ghana, Malawi, and Rwanda. Rwanda aims to become a cashless economy by 2024.’[21]

Technologically superior payment methods will obviously replace traditional banknotes permanently. Most consumers and merchants now rightly want to use these vastly more efficient means of payment. The fundamental problem here is that the disappearance of banknotes means the end of risk-free money for the public, the only money that has stable nominal value. Without banknotes, £10 will not always be £10, €10 will not always stay €10, nor will $10 always remain $10. This will remove the final line of defence against monetary policy without constraint and corporate money issuers.

STRENGTHEN THE NOMINAL ANCHOR OF YOUR INCOMES AND ASSETS

KEEP YOUR CASH IN YOUR HANDS

[1] The term government money is more precise and modern than sovereign money, but not exclusive.

[2] Access to Cash Review, Final Report, London, March 2019, p. 86.

[3] John Cunliffe, Deputy Governor (2020), It’s time to talk about money, Speech, 28 February 2020, p.6, 7.

[4] U.S. Department of the Treasury – Legal Tender Status (Resource Center).

[5] Aleksander Berentsen and Fabian Schar (2016), The fallacy of a cashless society, In: Cash on Trial, SUERF Conference Proceedings 2016/1, February 2016, p. 14.

[6] Christian Beer et al (2015), Cash on Trial, Findings from a conference, SUERF.

[7] McKinsey&Company (2019), Cash – an inefficient and outdated means of payment, Witnesses for the Prosecution, Cash on Trial Mk II, SUERF Conference, 20 May 2019.

[8] Frederich Schneider (2019), Restricting or abolishing cash: An effective instrument for eliminating the shadow economy, corruption and terrorism? In: Urs Birchler et al (eds.), Cash on Trial Mk II, Conference Proceedings 2019/1, SUERF, p. 53-66.

[9] Morten Bech and Amber Wadsworth (2019), What is money? Comparing cash and central bank digital currencies, In: Urs Birchler et al (eds.), Cash on Trial Mk II, Conference Proceedings 2019/1, SUERF, p. 24-31.

[10] Kenneth Rogoff (2016), The Curse of Cash, Princeton University Press, p. 15.

[11] Hans Binswanger (1994), Money and magic: a critique of the modern economy in the light of Goethe’s “Faust”, The University of Chicago Press.

[12] ‘The proposal here is driven by three guiding principles. First, the ultimate goal is to make it more difficult to engage in anonymous untraceable transactions repeatedly and on a large scale. … Second, the speed of transition needs to be slow, stretching changes out over at least 10-15 years. Gradualism helps avoid excessive disruption and gives institutions and individuals time to adapt. (p. 92) Third, it is essential that poor and unbanked individuals have access to free basic debit accounts (or the future equivalent), and possibly also basic smartphones, as several countries have already done or are contemplating.’ (p. 93). (Kenneth Rogoff (2016), The Curse of Cash).

[13] Marion Laboure (2019), Cryptocurrencies: the 21^st century cash, Imagine 2030, Konzept # 17, Deutsche Bank Research, December 2019, p. 58.

[14] Lawrence White (2018), The Course of the War on Cash, Cato Journal, Vol. 38, No. 2, p. 477.

[15] Kevin Dowd (2017), Killing the cash cow: Why Andy Haldane is wrong about demonetisation, Briefing Paper, Adam Smith Institute, London, April 2017, p. 1.

[16] ‘The main policy tactics in the war on cash are currently four: 1. Abolishing high-denomination banknotes. 2. Place a maximum legal value on cash payments. 3. Require declarations from any party carrying a cash amount above a specified value across the national border. 4. Require banks to report to authorities any cash deposits or withdrawals in amounts above (or suspiciously near) a specified value.’ Lawrence White (2018), The Course of the War on Cash, p. 478-9.

[17] Sveriges Riksbank (2019), Petition to the Riksdag – The state’s role on the payment market, Summary, p. 9.

[18] Wataru Takahashi (ed.) (2012), Functions and Operations of the Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, p. 55.

[19] ‘While we therefore see no reason currently to prohibit banks from issuing hand-to-hand currency, there is no pressure by banks or other groups to gain that privilege.’ Milton Friedman and Anna Schwartz (1987), Has Government Any Role in Money, In: Anna Schwartz (ed.), Money in Historical Perspective, NBER & University of Chicago Press.

[20] ‘As a result of the low fixed costs, cash payments up to an average payment amount of just under €20 are the most cost-efficiency for the retail sector.’ Deutsche Bundesbank (2019), The costs of payment methods in the retail sector, Monthly Report, June 2019, p. 107.

[21] Markus Massi et al. (2019), How Cashless Payments Help Economies Grow, BCG: Boston Consulting Group, May 28, 2019.

Coronavirus disease 19

An infinitesimally tiny bit of protein – a virus from the coronavirus family, the cause of the disease now known as Covid-19 – has altered the life of every human being on this small planet. It’s forced us to watch from our windows as spring awakens, confined to quarantine at home; to keep physical distance from others; and to wear face masks and gloves on the rare occasions when we do venture out. Coronavirus has shown us all how interconnected we are and laid bare the truth that there’s no room for Robinson Crusoe’s Island in our modern world. It has admonished us that we’re not superior but weak and vulnerable, in spite of all of our knowledge, technology, and resources. Coronavirus has made all people equal in this tribal world, where investment into tools that destroy life are thousands of times greater than in those that help it survive.

The scale of the Covid-19 scourge is revealed by the frightening daily statistics of infections and deaths by country, region, city, village, and, inevitably, for the world as a whole. It’s accompanied by the grim figures showing the extent of the Covid Economic Crisis,[1] the economic pandemic: the dizzying growth in unemployment, plunging production levels, and curtailment of domestic and foreign trade to just the bare necessities. Any decline in aggregate demand is, by definition, a prelude to economic recession. In terms of its depth and duration, the Covid-19 recession is already showing all the hallmarks of a depression. The medical and economic emergencies have elicited preventive action from all of the world’s governments and their departments.

The Covid-19 recession: Money for survival

In responding to the Covid-19 recession, the policymakers’ first instinct was to reach for money. Obviously, not their own, but ours – taxpayer money, money printed in profusion by central banks. Without a doubt, at this time of economic pandemic, every member of society must be entitled to the bare minimum required for life, regardless of their country’s budget deficit. Also without a doubt, the real sector must receive at least some of the assistance given to the financial sector during the 2007-2009 global financial downturn and lasting to this day. And yet, in doing so, the relative stability of goods and services prices must be maintained – a difficult but not impossible task, because there’s no reason to expect aggregate demand to grow during the pandemic. Curing the respiratory distress of the economy surely requires mechanical monetary ventilation, but for a limited time only, to reduce hardship faced by populations and prevent markets from collapsing.

Most governments have already temporarily relaxed their tax rules and provided fiscal support to small and medium-sized firms. Having learnt their lesson in the Great Depression of the 1930s, central banks ensured the financial system remained liquid and extended vast amounts in loans at zero or negligibly low interest rates. Central banks have also scaled up their purchases of safe securities issued by both banks and non-bank financial institutions and companies operating in the real sector.

At the same time, economists have lost no time in proposing various incentives, with some going as far as insisting that these remain in place permanently.[2] Although all of these stimuli are directly or indirectly linked to money, discussing them would take us too far from our topic – money in the time of coronavirus.

Support for recovery – NOT ‘helicopter money’

The pressing need for economic recovery has brought to the fore an old term, ‘helicopter money’, first used in a completely different context by Milton Friedman, the founder of modern monetarism. An erroneous interpretation of Friedman’s example,[3] which gained currency during the global financial downturn, became dominant in the Covid-19 crisis.

Proponents of the helicopter approach are growing ever more numerous. ‘There is an alternative … direct unrepayable funding by the central bank of the additional fiscal transfers deemed necessary, an intervention commonly known as “helicopter money”’.[4] This strategy, seemingly simple and effective, is one of the greatest threats to the real value of our money. Decades of low and stable inflation don’t mean that hyperinflation has been stamped out – just like with dangerous viruses.

These proposals have prompted central bankers to respond. In early April, Jerome Powell, Chair of the Fed, stressed that ‘these are lending powers, not spending powers. The Fed is not authorized to grant money to particular beneficiaries. The Fed can only make secured loans to solvent entities with the expectation that the loans will be fully repaid.’[5]

This is why it’s particularly important to distinguish between the functions, tools, and scope of fiscal policy, on the one hand, and those of monetary policy, on the other. In brief, this means setting the responsibilities of the Ministry of Finance and the Treasury apart from the role of the central bank.

The discussion about money-financed fiscal interventions has overshadowed a vignette in which our cash – or, more precisely, our banknotes – played the bad guy. Let’s take a quick look at the directors and stars of this one-act show, and see how things turned out.

Covid-19 dislikes cash

It took just one offhand remark made at a press briefing of the World Health Organisation to set off an avalanche of questions about whether cash could carry the virus. Use contactless payments, the world’s public health body said. And so, we learnt that cash was not just responsible for crime, terrorism, tax evasion, drug trafficking, and all other illicit activities, for monetary policy constraints and world wars (see Abolishing of Cash or Losing of Anchor), but for the coronavirus pandemic as well.

Nevertheless, the joy of global money providers, card network corporations, and private issuers of cryptocurrencies was short-lived. Soon afterwards, the MIT Technology Review retorted: No, Coronavirus is not a good argument for quitting cash, adding ‘[i]n fact, we don’t have any evidence that money in any form has ever been source of any kind of infection… You’re more likely to pick up COVID-19 from people exposure than from the type of payment.’[6]

One of the first central banks to wade into the fray was the German Bundesbank, which released a statement titled Cash poses no particular risk of infection for public: ‘… the risk of picking up coronavirus via cash is extremely minimal.’[7] Shortly thereafter, the Riksbank, the national bank of cashless Sweden, declared there was no evidence that the coronavirus spreads via banknotes.[8]

As may well have been expected, the most colourful answer came from Scotland: ‘The risk of banknotes spreading the coronavirus is small “unless someone is using a banknote to sneeze”, says Christine Tait-Burkard, an expert on infection and immunity at the Roslin Institute at the University of Edinburgh.’[9]

And so, thanks to the world’s immunologists and microbiologists, banknotes received a last-minute reprieve from the death sentence pronounced on them long ago by proponents of the cashless society. What’s more, they have proven to be a key means of preventing pandemic panic. No country may have had sufficient supplies of gloves, face masks, or ventilators, but all had ample stocks of banknotes, and all made this fact known in good time – like the Bundesbank, which reassured the public that ‘[t]he supply of cash is secure’ (18 March 2020).

Money after the coronavirus pandemic

Covid-19 will not exterminate the human race and neither will it eliminate money, for millennia the companion of humans and the omnipresent means of payment in each economy. Having said that, once the Covid-19 pandemic is over, money will be shaped by two key factors, the course of the outbreak and emergency economic policies, both fiscal and monetary. The macroeconomic lesson of the pandemic is clear: contraction of aggregate output and unemployment growth are proportional to the contagiousness and pathogenicity of any new virus or bacterium. Economic recovery will also be determined by the speed with which the pandemic is brought under control. Medical precautions can greatly dampen these consequences, but not prevent them outright.

Perhaps controversially, the Covid-19 pandemic may help keep the real value of money relatively stable by contracting aggregate demand. After all, inflation is hardly to be expected when most people have limited access to supermarkets and other retail outlets. Aggregate supply has also adjusted to the present circumstances and is not likely to put pressure on general price growth either.

Cash should see the same levels of use for several years to come, until people have forgotten about this pandemic, as they have forgotten the much more destructive Spanish Flu outbreak of 1918. The attention devoted to antibacterial and hygienic features of banknotes, already high, is set to increase further. In case you weren’t aware, ‘€5 and €10 banknotes, which change hands particularly often as change, additionally have a protective coating against soiling.’ (Deutsche Bundesbank, 18 March 2020).

With emphasis placed on resistance to germs, the introduction of polymer plastic banknotes is certain to pick up pace. The latest example of these is the new polymer £20 note, issued on 20 February 2020, and claimed by the Bank of England to be its most secure ever banknote. The retirement of the old £20 note will remove from circulation the image of Adam Smith, ‘the first economist and the first Scotsman to appear on a Bank of England note.’[10] Ironically, Adam Smith first appeared on a banknote in the spring of 2007, on the eve of the global financial crisis, and began to depart in February 2020, at the start of the Covid-19 pandemic in Europe. The replacement of old notes bearing his likeness will probably continue until the pandemic has died down, so his image will have linked two extraordinary episodes of economic history, the Great Recession and the Covid Recession (hopefully not Depression). If banknotes with the face of one of the fathers of economics are associated with such events, then no economist should ever be put on the money of any country anywhere in the world. What is certain, however, is that no economist will peek out at you from your wallet after the Covid-19 pandemic.

MAINTAIN PHYSICAL DISTANCE IN TIME OF THE PANDEMIC

KEEP YOUR MONEY IN YOUR WALLET

[1] Baldwin, R., Weder di Mauro, B. (eds.) (2020), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, CEPR Press VoxEU, March 2020.

[2] Paul Krugman (2020), The case for permanent stimulus, In: Mitigation the COVID Economic Crisis, p. 213-219.

[3] ‘“Wise” also means avoiding the deceptive lure of variants of so-called “helicopter money” or, in less colorful language, debt monetization. Given the considerable confusion surrounding this topic, it is worth dwelling on it for a moment. Helicopter money conjures up a powerful image money falling from the sky directly into people’s pockets. Choreography aside, though, it amounts to two rather mundane steps. The first is simply crediting individual accounts, just like the government does when paying out unemployment benefits or tax rebates. The second, less well understood, step is allowing the additional money to swell banks’ deposits with the central bank (technically, boost “excess reserves”) – that is where the money ends up. We have a pretty good idea of what their respective impact is; neither step is new. Transfers are the largest component of government spending. And the main central banks have operated with excess reserves for quite some time now. There is a consensus that simply adding to the reserves has little effect of its own on economic activity. It pushes on a string.’ Claudio Borio (2019), Wise fiscal policy is not about helicopter money, Speech, Bank for International Settlements, 08 November 2019.

[4] Jordi Gali (2020), Helicopter money: The time is now, In: Mitigation the COVID Economic Crisis, p. 57-61.

[5] Jerome Powel (2020), COVID-19 and the Economy, Remarks, Federal Reserve System, April 9, 2020.

[6] Mike Ocurt (2020), No, coronavirus is not a good argument for quitting cash, MIT Technology Review, March 12, 2020.

[7] Deutsche Bundesbank (2020), Cash poses no particular risk of infection for public, 18.03.2020.

[8] Sveriges Riksbank (2020), No evidence that the coronavirus spreads via banknotes, News, 26.03.2020.

[9] Rachael King and Alice Shen (2020), Will cash survive Covid-19? Central Banking, 20 March, 2020.

[10] Bank of England (2006), Governor’s Adam Smith Lecture 2006, News Release, 29 October 2006.