Thursday, February 9, 2017
Donald Trump doesn't like the strong dollar, but is there anything he can do about it?
Last month Donald Trump told the Wall Street Journal that American companies can’t compete "because our currency is too strong. And it’s killing us...” Trump's dislike of the strong dollar doesn't surprise me. I've known a few mercantilists over the years, and all of them have always been keen on trashing their home currency, the idea being that with a weaker currency domestic manufacturers will enjoy a shot to the arm. This in turn stems from the antiquated (and very wrong) idea that manufacturing is somehow the most important activity an economy can be engaged in.
Tweeting about one's desire for a weak dollar is one thing, but are there any actual levers Trump can pull on to affect the exchange rate?
U.S. exchange rate interventions are rare these days, with only two occurring in the last twenty years. In September 2000 U.S. monetary authorities intervened with other central banks to support the euro, and in March 2011 they bought yen after the earthquake that rocked Japan on March 11. The main concern of modern central bankers is their inflation target. To hit this target, interest rates have become the preferred tool. Unlike the gold standard or Bretton Woods era, the exchange rate has little role to play in this story, either as a target of monetary policy or as a tool.
Past efforts to fiddle with the dollar's exchange rate have typically been joint affairs taken on by the Federal Reserve and the Treasury. It makes sense to have the central bank as a partner because a central banker has the ability to create as much money as necessary in order to drive the exchange rate down. If Trump were to try to go it alone, he'd first have to go through the hoops of raising taxes or issuing bonds in order to get the requisite dollars to sell, this being a much weaker lever compared to the Fed's infinitely-powerful printing presses.
If Trump were to request that the Fed weaken the dollar, could Fed Chair Janet Yellen refuse to co-operate? The Fed could certainly dig in its heels. Anna Schwartz, channelling former Fed chairman Paul Volcker, notes that "the Treasury does not have authority to instruct the Federal Reserve to spend its own money on intervention and to take the attendant risks, and that the Treasury would be reluctant to intervene over strong objections of the Federal Reserve." This Peterson Institute publication provides an actual example of heel-digging. In 1990, most of the members of the FOMC were against continued purchases of Deutschmark and yen by George Bush, with three members voting against raising warehousing limits (see below for a description of warehousing) from $10 billion to $15 billion. While their push back wasn't enough to carry the day (the warehousing ceiling was increased), presumably it indicates that the Fed has a means for resisting Treasury demands, if not always the guts. The Fed has at times been dragged along as an "unwillingly participating" in Treasury-initiated interventions because—as Michael Bordo, Anna Schwartz, and Owen Humpage put it—appearing not to cooperate would "raise market uncertainty and could sabotage the operation's chance for success."
Given these conflicting views about the hierarchy between Fed and Treasury, when push comes to shove I don't know who would win out in a conflict between the two institutions. What seems sure is that any effort by Trump to arm twist the Fed into weakening the dollar would be controversial. If the Fed were to get its way, expect to hear outrage about the trampling of democracy by an "inbred" technocracy of academic economists. On the other hand, if Trump were to get his way he would be denounced for threatening the Fed's ability to keep inflation in check. As Goodfriend and Broaddus put it in this paper, Fed participation in Treasury-led foreign exchange operations has the potential to confuse the public as to whether monetary policy is supposed to support short-term exchange rate objectives or longer-term anti-inflationary objectives. Which is why Goodfriend and Broaddus advocate legislation that enforces a complete separation of the Fed from the Treasury's forex operations.
Let's imagine a Yellen-led Fed successfully rebuffs Trump. Does the President have any other levers to influence the dollar?
Enter the Exchange Stabilization Fund, or ESF. When the Fed and Treasury partner to intervene in foreign exchange markets, it has always been the ESF that has been responsible for the Treasury's contribution to the intervention. This obscure account, managed by the Treasury Secretary, is entirely self-funding. This means that, unlike the Treasury's other expenditures, spending from the ESF is excluded from the congressional appropriation process. Only the President, not Congress, has the authority to review the Treasury’s decisions regarding ESF operations.
The ESF has an odd history. It was established in 1934 by the Gold Reserve Act with $2 billion worth of proceeds derived from the revaluation of the U.S. gold from $20.67 to $35 per ounce. It has been used not only as the Treasury's counterpart to the Fed in exchange interventions, but also as a tool to bailout foreign governments, including a Clinton-led rescue of Mexico in 1995. Courtesy of George Bush and Henry Paulson, the ESF was most recently tasked with guaranteeing U.S. money market mutual funds during the 2008 credit crisis.
As of December 2016, the ESF's assets clock in at a cool $90.4 billion. How much of this might Trump devote to riding down the dollar? Take a look at the ESF's balance sheet and you'll see that of that $90.4, the ESF has $22 billion in U.S. securities. So it could sell $22 billion right now in order to push down the dollar.
Scanning through the rest of the balance sheet, the ESF also owns $50.1 billion IMF special drawing rights, or SDRs. (I wrote about SDRs here). The Treasury has the power to monetize these SDRs by depositing them at the Fed in return for fresh dollars. For the curious, I've snipped the relevant section from the ESF's statements:
To date, $5.2 billion worth of SDRs have been monetized, so presumably that leaves another $45 billion left as firepower. Note that the Fed cannot legally refuse to accept SDRs that have been submitted for monetization.
The ESF also has euros and yen to the tune of ~$19 billion. While it can't sell these currencies in order to weaken the dollar, it can exploit a long tradition with the Fed called "warehousing." If the Treasury Secretary wants the ESF to sell dollars but it lacks the resources to do so, the Fed has typically offered to buy the ESF's forex assets up to a certain warehoused amount in return for dollars, the ESF agreeing to take on the exchange rate risk. Think of this as a repo, securitized loan, or swap. According to the Treasury, this Fed-determined limit is currently $5 billion, although during the 1995 bailout of Mexico the warehouse was temporarily increased to $20 billion. So of the ~$19 billion in yen and euros on the ESF's balance sheet, at least $5 billion could be automatically converted into dollars and sold via the Fed's warehousing facility.
Where does that leave us? $22 + $45 + $5 billion = $72 billion. That's a lot of dollars that the ESF can potentially sell. But would it be enough to have a real impact the exchange rate? Foreign exchange markets are massive. According to the BIS, daily spot trading in U.S dollars averaged $1.4 trillion in April 2016! The ESF seems like a drop in the bucket to me, no? Furthermore, the Fed would become the ESF's biggest enemy in this game. If the ESF were to be successful in pushing down the dollar, this would constitute monetary loosening and would have to be offset by the Fed lest it miss its inflation target. Nor is Congress likely to top up the ESF's firepower, as Russell Green points out here, given the odds of success are low.
Suffice it to say that Trump can certainly score an initial symbolic victory by tasking the ESF to weaken the dollar, but he needs to have the unlimited firepower of the Fed if he wants to do true damage. And that firepower might not be forthcoming, at least as long as Janet Yellen—and not a Trump flunky—is holding the reins.
 One exception that Congress might agree to is the obscure $42.22 maneuver.
Monday, January 30, 2017
The topic of euro breakup has slowly been trickling back in the news, especially with the potential for Italy leaving the currency union, a so-called Italexit. In this post I want to explore one of the major conundrums that would-be exiteers must face; the problem of banknotes.
Almost all euro exit scenarios begin with the departing country announcing a shot-gun redenomination of bank deposits into a new currency, in Italy's case the lira. The effort must be sudden—if redenomination is anticipated ahead of time, depositors will preemptively withdraw funds from the exiting country's banking system, say Italy, and put them in the banking systems of the remaining members, say Germany, doing irreparable damage to Italian banks. After all, why risk holding soon-to-be lira when they are likely to be worth far less than euros?
Once the surprise redenomination has been carried out, the next step is to quickly introduce new lira banknotes into the economy. Lira deposits, after all, should probably be convertible into lira cash. This is much tougher than it sounds. Consider the recent Indian debacle. On November 8, 2016 Indian PM Narendra Modi demonetized around 85% of India's banknotes. Ever since then the Reserve Bank of India, the nation's central bank, has been furiously trying to replace the legacy issue with new currency. Because a nation's printing presses will typically only have the capacity to augment the stock of already-existing currency by a few percent each year, a rapid replacement of the entire stock simply isn't possible. India, which has been plagued with a chronic shortage of banknotes since the November announcement, is unlikely to meet its citizens' demand for cash until well into 2017. This in turn has hurt the Indian economy.
Like India, any Italian effort to print enough new lira paper to meet domestic demand could take months to complete. Without sufficient paper lira, existing euro banknotes would have to meet Italians' demand for paper money. Under this scenario, Italians would have to endure a messy mixture of electronic lira circulating with paper euros, reminiscent of the old bimetallic, or silver & gold standards, of yore. I say messy because everything in Italy would have two prices, a lira price and a euro price. In some ways this would be similar to the euro changeover period in 2002 when European shops displayed both euro and legacy currency prices on their shelves (lira, deutschemarks, francs, etc). The difference is that in the 2002 changeover the exchange rate was fixed, so the amount of mental arithmetic devoted to calculating exchange rates was minimal. In the case of Italexit and a new lira, the price of the lira would likely float relative to the euro, so the mental gymnastics required of Italians would be much more onerous.
If the Italian government were to attempt to fix this messiness by forcing retailers to accept euros and lira at a fixed rate, then Gresham's law would probably kick in. Because the government's chosen ratio is likely to overvalue the lira and undervalue the euro, Italians would hoard their paper euros (preferring to use them in Germany and elsewhere) while relying solely on electronic lira to buy things. This hoarding of paper euros, and the ongoing lack of paper lira, would likely lead to a severe banknote shortage, much like the shortages that India and Zimbabwe are currently enduring.
Some readers are probably wondering why Italy wouldn't try printing new banknotes ahead of the redenomination date. That way it could engineer a rapid lira changeover rather than a slow one. The problem here is that if Italian authorities take a preemptive approach, odds are that word will leak out that new lira are being printed, and depositors—spotting an impending redenomination coming down the road—will flee the Italian banking system en masse. So we are right back where we started. A successful Italexit requires that new lira banknotes be printed only after the redenomination has been announced, not before.
One technique that Italy might try in order to get lira paper into circulation as rapidly as possible is to use overstamping (described here). Once redenomination had been announced, Italian authorities quickly produce a large quantity of special stickers or stamps. They would then require Italians to bring in their euro banknotes to banks in order to be stamped, upon which those overstamped euros would no longer be recognized as euros, but lira. The window for getting euros stamped would last a week or two, after which the Italian government would declare that all remaining euro notes are no longer fit to circulate in Italy. Stamped notes would function as Italy's paper currency until the nation's printing presses have had the time to print genuine lira paper currency, at which point Italians would be required to bring stamped notes in for final conversion.
But even here Italy runs into a problem. An Italian with a stash of euro banknotes can either bring this stash in to be overstamped, and eventually converted into lira, or they can break the law and hoard said euros under their mattress. Hoarded euro note will still be valuable because they can be used to buy stuff in Germany, France, and in other remaining eurozone members. An overstamped euro, however, which has effectively been rebranded as lira, will be worth much less than before. Many Italians will therefore avoid getting their money stamped, preferring to get more value for their euro banknotes than less. And this means that Italy is likely to suffer a severe cash crunch, with euros being hoarded and new lira unable to fill the void fast enough, yet another manifestation of Gresham's law.
So any would-be euro exiteer faces several ugly possibilities, including a messy period of multiple prices to massive cash crunches.
It is because of these difficulties (and others) that I see euro exit as an incredibly unlikely proposition. The euro isn't a glove, it's a Chinese finger trap—once you've got it on, it's almost impossible to get out.
If there is to be an exit, the most likely one will be the euros without the Eurozone approach. Rather than announcing a new lira, Italy simply says that it will officially leave the Eurozone while continuing to use the euro unofficially. This means that Italian banks would continue to denominate deposits in euros and keep euro banknotes in reserve to meet redemption requests. The euro would still be used by Italian merchants to price goods, and euro banknotes would continue circulating across the nation. The difference now would be that the Bank of Italy would no longer have the authority to print euro banknotes. Instead, Italy would have to import banknotes from the rest of Europe, much like how Panama—a dollarized nation—imports U.S. banknotes from the U.S., as do Zimbabwe and Ecuador. By employing this sort of strategy, all the hassles I wrote about in this post (multiple prices & cash crunches) are cleanly avoided while at the same time an exit of sorts is achieved.
Tuesday, January 17, 2017
Earlier this month I criticized the architects of India's recent note demonetization for not using the traditional overstamping technique for replacing large quantities of banknotes.
This week I want to examine another feature of Modi's demonetization: the concurrent change in note sizing. The new series of ₹500 and ₹2000 notes are smaller in size than the ₹500 and ₹1000 series that they have since replaced. This has caused huge logistical problems. Since each cartridge in an ATM must be manually configured to handle a certain note size, ATMs were not equipped hold the newly issued ₹500s, ₹2000s, or additional ₹100s for that matter. Instead, they were forced to operate at a fraction of their capacity. Indians, desperate to replace their demonetized notes with good cash, were left on the lurch.
Let's explore the reduction in banknotes size. I'd argue that independent of the decision to crack down on black money, the decision to go smaller makes a lot of sense. But twinning a banknote size reduction with a demonetization was a recipe for disaster.
Consider that the length of the current issue of rupee banknotes grows as the denomination increases, like this:
Denomination: width x length
₹100: 73mm x 157mm
₹500: 73mm x 167mm
₹1000: 73mm x 177mm
To Americans and Canadians, this may seem odd since all our money is the same size. However, a pattern of progressively longer notes is quite common in other countries. Euro banknotes, for instance, also increase in size as denomination rises as do Swiss francs and Japanese yen. Presumably this format is chosen to to make manual sorting easier.
Now if the Reserve Bank of India, the nation's central bank, had continued to follow its traditional size progression, the newly issued 2000 rupee note would have had these measurements:
₹2000: 73mm x 187 mm
This would have been an awfully big note, one of the largest in the world by surface area. It would have clocked in 32% larger than a US$20 bill, for instance, and 43% larger than a 20 euro note. Not only would a note of this size have been expensive to print, but the combined costs of storage and handling incurred by hundreds of millions of Indians over time would have been quite large. Reducing the size would cut down on both expenses.*
The trend among central banks is to reduce the dimensions of banknotes. For instance, euro banknotes are quite a bit smaller than the francs, deutschmarks, and other notes that they replaced. The five euro note is one of the smallest notes in the world (see this pdf). When the Swiss began to introduce the ninth generation of Swiss banknotes in 2016, they lopped around 11 mm off the length of the 50 franc note and 4mm off its height (it now clocks in at 70 x 137 mm, down from 74 x 148). By doing so, the Swiss National Bank will be lowering manufacturing and handling costs of the currency. In the chart below, you can see the evolution of the dimensions of Swiss cash over time.
|Data source: Wikipedia|
So India's decision to reduce the size of the new notes is very much modern practice. 17mm has been removed from the length of the ₹500 note; it measures 150 mm rather than 167mm. As for its height, it has gone from 73mm to 66mm. The new ₹2000 note measures 66mm x166mm, a 20% reduction from what it would have measured had the RBI continued with its old progression. Presumably the RBI will eventually do the same with the smaller denomination like the ₹100 as well.
While a note size reduction makes sense, twinning it with an aggressive demonetization was a bad decision. To reduce the odds of damaging the economy, the void left by demonetized notes must be filled as rapidly as possible. In India's case, the discontinuity in banknote size interfered with this re-cashification process. The authorities should have split the two policies apart, say by enacting a gentle two or three-year conversion of existing notes to a new and smaller series, and only announcing a surprise aggressive demonetization of the two highest denomination notes four or five years from now, say in 2021.
Alternatively, the authorities could have proceeded with their November 8 aggressive demonetization, but without enacting a note size reduction. The RBI should have taken incoming demonetized 500 and 1000 rupee notes and stamped them for re-circulation to ensure the banknote supply was sufficient, as I went into here. By using existing banknotes, ATMs cartridges would not have required adjustment. As for the new ₹500 note, it should have been the same size as the old series to ensure that cash distribution worked smoothly. Then—say five years from now—the Reserve Bank of India could have gradually phased in reduced note sizes for the entire range of denominations from the ₹10 to the ₹2000. This would have cut down on the chaos of the last few months.
The RBI seems not have been involved much in the planning stage of demonetization. According to recent press reports, the Board was "asked" to consider the demonetization just a day before it was enacted and had not discussed the matter before then. This is a shame. While an aggressive demonetization needs to be planned in secret, as I pointed out here, having at least a few closed-mouth central bank types involved from the outset seems like a basic requirement. They might have been able to fix the mistake of combining a demonetization with a note reduction.
*On the other hand, there are arguments for increasing note size too. See Garber.
Sunday, January 15, 2017
In a recent podcast with Robert Hall, Russ Roberts asks:
"If the Fed was so aggressive, why didn't we have inflation? And does that mean that Milton Friedman and others were wrong?"It's a good question. Because I find monetary policy confusing, I want to try answering Russ's question with an analogy to an example that doesn't involve money.
Say there are two types of gold rings, those with diamonds and those without. The price of gold rings with diamonds exceeds the price of rings without diamonds by a wedge that equals the price of the diamond.
A technology emerges that can create diamonds at zero cost. The supply of diamonds will rapidly grow until they become like water; while boasting desirable qualities, a diamond will sell for $0. When this happens the price of gold rings with diamonds will equal the price of gold rings without.
Using this analogy, we can understand why—despite having been so aggressive—the Fed didn't create inflation. Treasury debt and Fed debt are alike in that they are both government liabilities. However, Fed debt comes with an extra cherry on top; it can be spent anywhere. Government debt... not so liquid. This mobility is a valuable commodity and people will (typically) pay a premium to own it. So we might say that Treasury debt is very much like our plain gold band, and Fed debt is like a gold band with a diamond attached to it.
When the Fed expands aggressively, it does so through open market operations, or by spending its own Fed debt to acquire Treasury debt. What effect do these operations have?
Let's look at how open market operations would work in the ring market. A ring producer that has developed a technology to create diamonds at zero cost begins to "spend" new gold bands (with diamonds) into the economy by purchasing gold bands (without diamonds). The number of gold bands in the economy will stay constant (x gold is being swapped for x gold). But the quantity of diamonds in the economy increases. On the margin, diamonds are becoming less valuable, and so the price of gold bands with diamonds falls. We get inflation in the price of gold bands with diamonds.
However, this inflation will eventually come to a stop. Once the price of diamonds has fallen to its lower bound of zero, the price of rings with diamonds will equal the price of a rings without. Subsequent spending by our ring producer of new gold bands with diamonds into the economy will have no effect—all that is happening is a swap of a gold band for a gold band, and a swap of like-for- like has no macroeconomic effect.
And that's why the Fed's aggressiveness (QEI-III) has had little effect on prices. Once the Fed has conducted enough open market operations, the useful commodity attached to Fed debt that we call mobility—much like the diamond in our previous example—becomes so prevalent that on the margin it is worth zero. At this point, Fed debt loses its uniqueness and is exactly the same as Treasury debt. All subsequent purchases are irrelevant because the Fed is simply switching like-for-like. Thus the Fed, like our ring producer, has lost the ability to create inflation via open market operations.
Friday, January 6, 2017
|1913 Austro-Hungarian banknote with 1919 Czechoslovak overstamp|
When Indian PM Narendra Modi and his small group of would-be monetary architects were putting together their plan to suddenly demonetize the 500 and 1000 rupee note and replace them with new notes (including a new 2000 rupee note), they must have been missing a monetary historian. That's because there is a long history of nations suddenly demonetizing the entire circulating paper issue and introducing a new paper currency. These rapid switches have tended to follow a well-trodden script, one that Modi did not follow. Had he chosen to adopt it, the last two months might have been less chaotic.
One challenge faced by any prospective note switcher is to print the new currency fast enough to replace the legacy notes. When the switch is a slow one that is planned long beforehand, like the euro introduction, this is not an issue. In the case of a rapid switch that cannot be prepared for, however, the printing challenge is overwhelming. In India's case, pre-printing notes was not the answer. Because its goal was to surprise a large number of cash-users with undeclared cash, the rupee switch had to be sudden—printing large batches of notes ahead of time might have tipped off the prey. Without enough currency, however, an economy undergoing a switch is cursed to endure a temporary cash crunch, much like the one India has experienced. To cope with the period between the demonetization of the old notes and the issuance of new ones, nations have resorted to an old monetary trick called overstamping.
The 1993 conversion of old Czechoslovak koruna into new Czech and Slovak money is the best modern example of a successful rapid currency switch, thanks in no small part to its use of the overstamping technique. With the January 1993 dissolution of Czechoslovakia into Slovakia and the Czech Republic, the public also anticipated an ensuing breakup of the still-circulating Czechoslovak koruna into two national currencies. Since Czech was expected to be the more economically robust of the two nations, depositors began to move their paper money and bank accounts to the Czech side of the border to ensure their savings would be held in the stronger of the two soon-to-be currencies.
Anxious to put an end to capital flight before it crippled the monetary systems of the fledgling nations, the Czechs and Slovaks were forced to introduce new monetary units ahead of schedule. Unfortunately, the banknotes hadn't been printed yet. As a temporary expedient, the monetary authorities decided to affix different coloured stickers, or stamps, to existing Czechoslovak banknotes in order to demarcate them as either new Czech koruna or new Slovak koruna.
In executing a currency switch, affixing stamps on existing legacy notes has several advantages over relying entirely on new banknotes. Stamps take far less time to design and print than banknotes, they can be rapidly distributed thanks to their small size, and they are cheaper to store. In the case of Czechoslovakia, for six days in February 1993 all koruna banknotes were brought in so as to have the proper Czech or Slovak stamp affixed to them (below is a legacy koruna note with a Czech stamp on it). After the six day period passed, any unstamped currency was declared worthless. Cross border movements of cash between Czech and Slovakia were made illegal for that period and cash withdrawals from banks suspended.
|1985 Czechoslovak koruna with yellow overstamp (top left)|
Once the new notes had been printed up, Czechs and Slovaks could bring their stamped legacy notes to the bank to get new ones. All in all, it was a relatively smooth currency switch.
As I said at the outset, there is a long history to currency swaps. In 1919, the existing Austro-Hungarian krona was dismembered, with each of Czechoslovakia, Serbia, Hungary, Austria, and Romania printing unique stamps to be affixed to the krona circulating in their jurisdiction. Once new notes had been printed, stamped krona could be brought in for redemption. Peter Garber and Michael Spencer go into some detail on this episode here. As for the general practice of affixing stamps to money, I'd suggest Arnold Keller and John Sandrock here.
Zooming forward in time, to fill the void vacated by demonetized banknotes Modi's planning team decided to rely entirely on the ability of the Reserve Bank of India (RBI) to print new currency. And that's where its problems began; with 24 billion pieces needing to be printed, there simply wasn't enough time. Blogger James Wilson calculates the replacement effort might not be completed till as late as September 2017:
Long lineups developed at banks and, without enough cash to go around, trade has been impaired. Had it borrowed from the above precedents, Modi's demonetization team might have been able to avoid at least some of this mess by procuring a supply of several billion worth of stickers or stamps. Some of these could have been printed and hoarded by the government in the months prior to November 8, the rest could have been printed on demand after the announcement date. The trick would be to ensure that the stamps had enough special security features so that, once issued, they succeeded in throwing off counterfeiters, who would have a strong incentive to make fakes for sale to those who had large amounts of undocumented cash.
Under a stamp scheme, come the November 8 demonetization announcement the RBI would have distributed the stamps to banks. Members of the public could then bring their demonetized notes to their local bank in order to have them stamped, up to a certain quota. These stamped notes would quickly reenter circulation, helping close the void left by the sudden demonetization of 80% of India's money supply and the slow trickle of newly-issued 500 and 2000 rupee notes entering the economy. Once the RBI had managed to print enough 500 and 2000 notes, it would set some fixed conversion period for turning in stamped 500 notes and 1000s for new notes.
It could be that Modi's team considered a stamping mechanism and decided against it for some justifiable reason that I'm not aware of. Or perhaps they simply didn't do their homework. If they didn't, overstamping could very well have diminished the shock faced by the Indian economy over the last few weeks. Countries that decide to follow India's path in the future would do well to include it in their plans.
Thursday, December 15, 2016
We are more than thirty days into Narendra Modi's demonetization campaign, and while many of the commentators I follow say that it is admirable of Modi to try to reduce the role of black money (wealth held by tax-evaders and criminals) and increase digital money adoption, most say that demonetization is not the way to go about it.
In short, the idea behind Modi's demonetization is to reqiure everyone who owns old 1000 and 500 rupee notes to bring them to a bank before year-end for conversion into new banknotes or to be deposited into an account. By forcing Indians to re-familiarize themselves with dormant accounts, or open new ones, the architects of the plan hope that India's reliance on cash as a medium of exchange will be reduced. Any amounts above the ceiling require proper documentation. Those who own large amounts of cash for undocumented reasons, either because they are evading taxes or engaging in criminal behaviour, will therefore be unable to make the switch, their money expiring worthless by year's end. Having been taught a lesson, they may choose to permanently move some of their operations into the official sector.
Kaushik Basu, World Bank chief economist from 2012-2016, is particularly pessimistic about the policy, noting that while he agrees with the Reserve Bank of India's estimate that the economy will probably grow at 7.1% in 2016-17, from 7.6% estimated earlier, he expects a "huge drop" in the economy next year. "Money works like blood," says Basu, invoking one of the Physiocrat's classic analogies of the economy to the human body.
I certainly agree with Basu's use of the money-as-blood analogy, but my hunch is that temporary media of exchange will spring up to take the at least some of the space heretofore occupied by Modi's demonetized banknotes. My mental model for understanding demonetization is the Irish bank strike of 1970. For six months banks were shuttered, Irish citizens entirely cut off from their bank accounts. Cheques could not be deposited, nor could the central bank use the branch banking system as a means to get paper money into the economy.
India can cope without cash for a few days. In 1970, Irish banks closed for six month: the economy did just fine. https://t.co/TB8n53wqal pic.twitter.com/qXcw3EEc9v— JP Koning (@jp_koning) November 14, 2016
Rather than suffering a huge blow, the Irish economy continued to function as it did before. Into the void vacated by banks and cash, post-dated cheques emerged as a the economy's blood, its circulating medium of exchange, with pub owners acting as informal credit evaluators.
Like Ireland in 1970, India suddenly finds itself deprived of a large portion of its money. In the place of 1000 and 500 rupee notes I expect informal credit to take some of its place, the effects on the economy therefore not being as devastating as Basu hints. See for instance this:
While many commentators are already declaring the demonetization to be a success or a failure, we won't have a good sense of this for several years. What sort of data should we be evaluating along the way? One of the effects we'd expect to see in a successful policy is a long-term reduction in the usage of cash, both as licit users of banknotes are diverted into the banking system and illicit users, burned by the forced switch out of old 1000 and 500 rupee notes, migrate out of the underground economy into the official economy. This should be reflected in data on India's currency in circulation, an attractive indicator in that is simple, accurate, not subject to revision, and comes out on a weekly basis. You can download the data here under the section 'Reserve money'.
The chart below shows the number of rupee banknotes outstanding going back to 2001. Prior to the demonetization, cash had been growing at a rate of 14-15% per year, as illustrated by the blue trend line. Since then you can see that there has been a huge collapse in quantity outstanding as Indians queue to deposit their cash in the banking system. At the same time, the Reserve Bank of India (RBI) hasn't printed enough new 500 and 2000 rupee notes to meet demand.
Cash in circulation will inevitably rebound in 2017 as the RBI catches up to demand by printing new rupees. If cash in circulation jumps back to the pre-demonetization level of ~18 trillion rupees and proceeds to readopt its growth path of 14-15%, than the demonetization will have failed to generate the desired effect. Despite suffering through queues and a relatively sluggish period of aggregate demand, Indians will have returned to their old habits, the whole demonetization campaign being a waste of time and effort.
But if cash in circulation only retraces part of the rebound, say rising to 16 trillion rupees by mid- 2017 (it is currently at ~10 trillion), and then sets out on a new and lower growth path (say 12-13%), then it will have achieved at least some of the desired effect. A new growth path starting from a lower level would imply that the demonetization has been successful in modifying the behaviour of licit cash users (i.e. converted them into digital money users) while driving illicit users of cash into the official economy.
My hunch is that of these two possibilities, the second is more likely: India will see a reduction in the growth path of rupee banknotes starting from a lower plateau. That being said, I find myself sharing many of the worries that Basu and other commentators have. Such a large and aggressive demonetization is a risky way to achieve the twin goals of broadening India's official economy and increase electronic money use. In order to catch people by surprise, much collateral damage must be inflicted, including time wasted in lineups and trades that go unconsummated due to a lack of cash (informal credit as in the case of Ireland not being able to completely fill the void). Suyash Rai makes a convincing argument that a demonetization of this size intrudes on property rights and rule of law.
Despite the chaos it has created, I still feel that the demonetization will make India at least a bit better off than before. However, other nations with large underground economies and low digital money uptake should be wary of copying India's example, waiting at least three or four years to gauge the final outcome. Rather than Modi's risky shock-and-awe approach, a better way to solve the problem is through a series of small and gradual measures. One of these steps might include implementing the approach Kaushik Basu writes about in his 2011 paper Why, for a Class of Bribes, the Act of Giving a Bribe should be Treated as Legal. See my post here for a full explanation.
Here's another incremental maneuver. Instead of imposing a short period of time for switching out of a limited quantity of 1000 and 500 rupee notes, why not allow three or four years for unlimited amounts of notes to be converted—but design the new notes to be 40% larger than the demonetized ones, as Peter Garber suggests, thus making it harder for Indians to store and handle cash?
Another step would be to copy Sweden which, thanks to several policies enacted over the last decade or so, is the only nation in the world with declining cash in circulation. One reason: retailers are required to use certified cash registers that prevent cash-induced tax gas. The Swedes have also adopted tax policies that encourage reporting of activities that typically remain in the unofficial economy, as I explain here. I also recently learnt from Miles Kimball that the Riksbank, Sweden's central bank, privatized the banknote distribution system in the 2000s, the effect being to end the subsidization of note transportation. If banks must bear the true (and higher) cost of moving notes around India, then this will be passed onto their customers, who in turn will react by switching into cheaper digital alternatives. I plan to write about this next week.
The advantage of many incremental steps towards increased digital money usage and a smaller underground economy is that should one step go bad, the blast radius will be small. One large Modi-style step might get you there faster, but if it goes awry, it risks upending the entire effort.
Wednesday, December 14, 2016
|From the website IPaidaBribe.com|
A few months ago I stumbled on Kaushik Basu's fascinating and readable 2011 paper Why, for a Class of Bribes, the Act of Giving a Bribe should be Treated as Legal. In the context of Narendra Modi's massive demonetization campaign, which has as one of its goals a reduction in corruption, I thought it was a timely moment to shine the spotlight on Basu's idea.
One reason that bribery often goes undetected by authorities is that the bribe giver and the bribe taker are incentivized to cooperate with each other in order to keep a bribe secret. After all, the law typically treats both parties as equally guilty—work together and no one gets in trouble. Basu's idea is to upend this symmetry by having the bribe giver face a different set of consequences than the taker should the bribe be made public. Once they face different fates, the motivation that the giver and taker have to cooperate will disappear, or at least be diminished, making it easier for the authorities to cut down on bribery.To reduce bribery, the act of giving a bribe should be legalized, suggests World Bank Chief Economist @kaushikcbasu https://t.co/xORxMAjcNq pic.twitter.com/bqOI0uOI36— JP Koning (@jp_koning) September 25, 2016
In the case of a specific kind of bribery, harassment bribes, Basu proposes completely legalizing the act of giving a bribe while maintaining the prohibition against the taking of a bribe. Harassment bribes are amounts that must be paid to get government services to which one is legally entitled to, say like an official who requires a 'gift' before stamping a document or a teacher who won't correct his/her students' final exams without passing around a hat.
In addition to granting the bribe giver full immunity, Basu also wants to implement a requirement that the taker, once convicted, pay the giver back. By removing the symmetry of a bribe transaction, the profit and loss calculus faced by the bribe giver is dramatically altered. If they successfully offer a bribe and then report it, not only does the bribe giver get the required service that the official had been withholding—they also get the full amount of the bribe returned to them.
It also alters the calculus faced by the taker. Knowing that he/she can no longer count on a giver's cooperation post-bribe, the bribe taker will now suspect that all bribes offered and solicited will be made public after the fact by the giver. Far safer to simply stop asking for or accepting bribes.
What about other types of bribes, say like a bribe paid to win a government contract? Here Basu suggests that while the giving of this sort of bribe should not be legalized, the giver should face a more lenient penalty than the taker so as to reduce their motivation to collude.
A policy of allowing bribe givers to tell on bribe takers can backfire, as Basu points out in a more formal paper. Say that a government legalizes the act of giving a bribe, but that the probability of a bribe-giver's information being acted upon by the government is low (perhaps a very high bar for conviction has been set or the department for registering cases of bribery is not sufficiently responsive). In this case, the expected penalty for bribe-taking remains small enough that bribery will not be abolished. Rather, average bribe sizes will rise since government officials will require more compensation to make up for the odds of being detected. Since the same nations that suffer from bribery may be the same ones that fail to run effective departments for taking complaints about bribery and verifying them, the odds of policy failure are not small.
Another problem with this scheme is that it might encourage citizens to blackmail government officials. After all, once a bribe-giver has lured an official into accepting a bribe, he/she can now turn around and tell the official that without some form of compensation, the bribe will be revealed. In response to this, Basu notes wryly that "there is nothing fool-proof in economic policy design," but also suggests increasing the punishment for blackmail.
If the idea of legalizing bribe-giving seems odd on first pass, just think of it as a whistle blowing rule, say like the one recently implemented by the SEC. Whistle-blowing laws are designed to break the psychological incentive for employers to go along with their rule-breaking employees. After all, deviating from an employer-enforced consensus can cause a lot of stress. An offer of financial aid may go some distance to alleviating what is sure to be a difficult experience. In the same way that Basu's legalizing of bribe-giving deputizes bribe givers to come forth and help the authorities pinpoint fraud by government officials, compensation for employees deputizes them to pinpoint corporate fraud.
As I pointed out in this post, Modi's demonetization is a gamble. Sure, it could work out magnificently. But at what cost? With no academic literature documenting the effect of aggressive demonetizations on black market activity, it's hard to know what to expect. While my sense is that the demonetization will probably enjoy some degree of success, a series of incremental changes—including a legalization of bribe-giving (for which their exists a growing body of empirical literature)— would be a far more certain, albeit less dashing, strategy for encouraging growth in the official sectors of developing nations.
Friday, December 2, 2016
"America's only unwanted, unhonoured coin."
- John Willem on the silver trade dollar.
The inspiration for this post comes from the old trade dollar, a U.S. silver coin that was minted in the 1870s and 1880s for the sole purpose of circulating in China. Taking the trade dollar as a model, I'm going to discuss the idea of converting the U.S. $100 bill into a trade bill; i.e. to limit it to foreign and not domestic usage.
Why bother modifying the $100 in this way? While not entirely convinced, I do lean towards Ken Rogoff's idea of getting rid of high denomination banknotes like the Canadian $100, the Swiss 1000 franc, and the Europe's €500. These bills are used primarily by criminals and tax evaders; their removal will make these activities more costly. The public's licit demand for a private means of payment can be met by low denomination notes, as can the necessity for a convenient physical payments medium on the part of the unbanked.
But as I wrote here, the Federal Reserve's $100 is categorically different from the above banknotes. The the dollar plays a special role as the world's backup medium of exchange and unit of account. Abolish the $100 and not only will those dollarized countries already using U.S. banknotes (many of them poor) be hurt, but so will the desperate citizens of foreign countries who might try to flee to the dollar in the future due to the awful monetary policies of their leaders, usually dictators.*
By converting the $100 into a trade bill, everyone can have their cake and eat it too. Like the old silver trade dollar, the $100 trade bill will be barred from playing a role in the U.S. economy, thus doing damage to the domestic underground economy. But it will be free to be used in places like Venezuela which, thanks to misgovernance, are in urgent need of a better monetary standard.
To help determine the structure of a modern $100 trade bill, let's explore the design of the 19th century silver trade dollar. China had a long history of using silver as money, and as trade with the west grew the Spanish silver dollar—minted in Mexico—had become quite popular with Chinese merchants. U.S. traders were penalized as they had to acquire Mexican dollars at a premium to the coin's intrinsic silver value in order to do business with China. Enter the trade dollar. The idea was to introduce a U.S. equivalent to the Mexican dollar in order to help out U.S. merchants, who would no longer have to pay a premium. The trade dollar would also provide domestic silver producers, an important political constituency, with an outlet for their production.
While U.S. legislators liked the idea of having U.S. silver coins circulate overseas, they did not want the trade dollar to be used in the U.S. After all, the U.S. was in the midst of giving up the old bimetallic standard (silver and gold) in favour of a gold standard, and a new silver coin might interfere with this process.
Thus, we arrive at the Coinage Act of 1873, which simultaneously took the U.S. off of silver (by ending the free coinage of silver) while also introducing the trade dollar. To ensure that the trade dollar would not be "made a part of or be in any way confounded with our monetary system," its legal tender status was limited to $5 i.e. no domestic debt could be extinguished with more than $5 in trade dollars (for a review of legal tender, go here). To further hurt its domestic usefulness, this legal tender status would be completely revoked in 1876.
While the trade dollar was well-received in China (most of them were chopped), it wasn't entirely successful in staying out of domestic U.S. circulation. According to Garnett, of the $35.9 million in trade dollars coined, $29.4 million were exported. Of this amount, $2.1 million returned to the U.S., joining the $6.6 million that had never left the country.
It's important to understand why trade dollars sometimes stayed in the U.S.—after all, the idea of a trade bill simply won't work if $100 notes continue circulating in the U.S. There seems to be two reason for this. From 1873 until 1876, trade coins still had a limited value as legal tender. At first, this wasn't an issue. Since the intrinsic value of the coins' silver content exceeded their official legal tender value, it made little sense for Americans to use them to settle local debts—debtors would be effectively overpaying if they did so. However, as silver prices fell through the 1870s the official legal tender value of trade dollars began to exceed their intrinsic value, at which point it was profitable for debtors to pay off their bills in overvalued silver trade dollars. This would have diverted trade dollars from China in order to meet local demand.
Secondly, speculators began to buy trade dollars in China and bring them back home on the expectation that the U.S. government would eventually redeem them at their original value of $1, even as they traded at around 80 cents on the dollar. This belief was eventually realized in 1887 when Congress compelled the government to redeem all trade dollars at par.
So with these design flaws in mind, let's design our $100 trade bill. To begin with, on January 1, 2017 the U.S. government will announce its intention to rescind the legal tender status of $100 bills. That means the $100 can no longer be used by a debtor to discharge any U.S. debt. Legal tender status must be entirely rescinded to avoid the mistakes of the trade dollar.
Next, the Federal Reserve announces that after a certain date (say January 1, 2019), all domestic deposits and withdrawals of $100 notes will be illegal. Until then, the public enjoys a two-year window for bringing bills into banks or Federal Reserve branches for conversion into $20 bills or deposits. To prevent local hoarding of $100 bills, the domestic closure of the "$100 window" must be perceived to be permanent. Remember that trade dollar inconvertibility was perceived to be temporary, thus encouraging domestic demand. Likewise, if they anticipate a re-opening of the "$100 window," Americans will simply keep their $100s at home.
Banning local redemption will likely force all local retailers, wholesalers, and other businesses to stop accepting $100 bills. A retailer like Walmart that receives a $100 bill during the course of business will have to ship it overseas to be spent or deposited, and that would be quite expensive. Likewise, licit person-to-person exchanges of $100s will be crimped. Lacking domestic acceptance by banks and retailers, the $100 will have no liquidity, and regular people will no longer be willing to accept them.
For these same reasons, illicit domestic usage of $100s will suffer. Since no legitimate businesses will accept them, criminals won't be able to spend $100 notes into the local economy. To launder $100 bills, it will now be necessary to send them overseas for deposit into foreign banks. This will impose significant handling costs on money launderers, especially if the government institutes laws that limit large cash exports. These handling costs will probably be high enough to force domestic illegal currency users to migrate to $20 bills as their preferred medium.
While domestic usage of $100s will rapidly decline, foreign-based banks will be completely free to allow deposits and withdrawals of $100 banknotes, much as they do now. To get $100 notes shipped from the U.S., foreign banks will have to put in orders with a Federal Reserve bank (they tend to prefer the New York Fed's cash office and, in the West, the San Francisco Fed's Los Angeles cash office). To redeposit $100 bills, they will have to send them by plane back to New York.
This setup should be sufficient to flush most $100 bills out of domestic circulation, forcing U.S.-based criminals and tax evaders to fall back on less convenient $20s. And just as the trade dollar successfully met Chinese demand for silver money, the $100 trade bill will meet Panamanian, Zimbabwean, and other foreign demand for U.S. high denomination cash.
*Rogoff believes that a policy of removing high denomination notes should only be enacted by developed nations. But since so many undeveloped nations use the dollar, Rogoff is being inconsistent in calling for an end to the $100.
To read more about U.S. trade dollars, here are some good sources:
A Trade Dollar Song and Chorus, 1883 (link)
Collecting Trade Dollars (link)
The History of the Trade Dollar (link)
The British (link), Japanese (link), and French (link) also issued trade dollars
Milton Friedman wrote an excellent account of the switch from bimetallism to the gold standard (pdf).
Friday, November 18, 2016
|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.