Is the strength of U.S. sanctions due to U.S. dollar hegemony?

I often hear the idea that the U.S. dollar is the means by which the U.S. implements sanctions. And since the U.S. dollar pervades all corners of the globe, the U.S. government's sanctions are uniquely powerful. For instance, Reuters reports that Russian resource giant Rosneft is shifting all its contracts over to euros in order to "shield its transactions from U.S. sanctions."

Another version of this idea was recently floated by David Marcus, the head of the Libra payments project:

"The future in five years, if we don’t have a good answer, is basically China re-wiring” a large part of the world “with a digital renminbi running on their controlled blockchain,” Marcus said. He warned about the prospect of “having a whole part of the world completely blocked from U.S. sanctions and protected from U.S. sanctions and having a new digital reserve currency” with no alternative."

The shared assumption of both the Rosneft and David Marcus quotes is that the U.S dollar is the primary pathway for projecting U.S. sanctions. By going out of their way to adopt a different currency, euros or renminbi, a nation or corporation can sidestep the sanctions threat.

But that's not quite right. Sure, the U.S. dollar is the world's reserve currency. However, the U.S.'s ability to apply strong and effective sanctions has very little to do with the U.S. dollar itself.

To see why, we need to visit how sanctions work. If the U.S. doesn't like a particular company, say Rosneft, and wants to cripple it, it starts with primary sanctions. The government tells U.S. companies to stop dealing with Rosneft on threat of fine.

But the real story begins with secondary sanctions. Here, the U.S. government tells Americans that on top of breaking ties with Rosneft, they must stop doing business with all other foreign entities (European, Canadian, Japanese, etc) that does business with Rosneft.

A foreign company now has a choice. If it is a European refiner, it will have to choose between continuing to buy crude oil from Rosneft or no longer accessing U.S. markets. This means being shut off from U.S. energy exports, doing without Texan oil & gas technology, forgoing U.S. repairs and refinery parts, being exempt from Silicon Valley tech expertise, being excluded from purchasing American assets, and having its existing U.S. subsidiaries threatened. There are also financial repercussions. It will lose access to New York's capital markets and the dollar payments system.

Given a choice between Rosneft or America, which will our refiner choose?

As I wrote a while back at Bullionstar, their are additional costs to being blacklisted by the U.S. government. Blacklisted executives would have to face the possibility of "no longer being able to send their kids to Ivy league schools, travel to Las Vegas for holiday, or seek medical care at Johns Hopkins or the Mayo Clinic." They wouldn't be able to visit the U.S. for business purposes, or explore U.S. job opportunities. I doubt that Russia has enough good job opportunities, universities, vacation spots, and high end hospitals to compensate.

This impressive list of penalties is why the U.S. government's secondary sanctions are so powerful. Almost every foreign company will prefer to give up Rosneft and keep doing business with America.

Now, Rosneft might nudge and wink at its European customers and say "hey, let's just deal in euros. That way we can get around the sanctions. We'll keep doing business together and you won't lose access to the U.S."

But using euros doesn't change the economic calculus facing our refiner. Even if it does business with Rosneft in euros rather than dollars, it is still doing business with Rosneft. And the moment that the U.S. justice department catches a whiff of this (say one of its bankers rats it out), the European company will be blacklisted. And that means losing the entire list of goodies that is associated with access to America. The risk is simply too high.

Fancy payment options like bitcoin or gold don't solve this either. Say that Total, a big European refiner, buys Rosneft oil with bitcoin. Total execs hopes that a bitcoin payment might prevent its bankers from tattling on it to U.S. authorities. But it's very difficult to camouflage the opposite side of that trade--massive movements of crude oil back to Europe. There are just too many bodies involved in that sort of operation. A large law-abiding organization like Total can't take the risk of being discovered. And so, bitcoin or not, it will disconnect Rosneft.

To summarize, what makes American secondary sanctions so effective isn't U.S. dollar hegemony. It is the impressive amount of technology, wealth, goods, services, and experience generated by American companies and individuals. When firms are threatened with losing access to this treasure trove, they will make whatever sacrifices are necessary to keep it.

As for Libra, in an effort to sell his new payments system to American regulators, David Marcus conjured up a world "completely blocked from U.S. sanctions" thanks to a new digital renminbi. But even if firms have the ability to make transactions in digital renminbi, this doesn't change the fact that America's home-grown economic bounty is massive, and foreigners value that bounty above any other, U.S. dollar or not. There are other reasons for regulators to welcome Libra. But bolstering U.S. sanctions isn't one of them.

Norbert's gambit

I executed one of the oddest financial transactions of my life earlier this week. I did Norbert's Gambit.

These days a big chunk of my income is in U.S. dollars. But since I live in Quebec, my expenses are all in Canadian dollars. To pay my bills, I need to convert this flow of U.S. dollars accumulating in my account to Canadian dollars.

Outsiders may not realize how dollarized Canada is. Many of us Canadians maintain U.S. dollar bank accounts or carry around U.S. dollar credit cards. There are special ATMs that dispense greenbacks. Canadian firms will often quote prices in U.S. dollars or keep their accounting books in it. I suppose this is one of the day-to-day quirks of living next to the world's reigning monetary superpower: one must have some degree of fluency with their money.

Anyways, the first time I swapped my U.S. dollar income for loonies I did it at my bank. Big mistake. Later, when I reconciled the exchange rate that the bank teller had given me with the actual market rate, I realized that she had charged me the standard, but massive, 3-4% fee. In an age where the equivalent fee on a retail financial transaction like buying stocks amounts to a minuscule $20, maybe 0.3%, a 3-4% fee is just astounding. But Canadian banks are an oligopoly, so no surprise that they can successfully fleece their customers.

So this time I did some research on how to pull off Norbert's gambit, one of the most popular work-a rounds for Canadians who need to buy or sell U.S. dollars. From a moneyness perspective, Norbert's gambit is a fascinating transaction because it shows how instruments that we don't traditionally conceive as money can be recruited to that cause. The gambit involves using securities listed on the stock market as a bridging asset, or a medium of exchange. More specifically, since the direct circuit (M-M) between U.S. money and Canadian money is so fraught with fees, a new medium--a stock--is introduced into the circuit (like so: M-S-M) to reduce the financial damage.

To execute Norbert's gambit, you need to move your U.S. dollars into your discount brokerage account and buy the American-listed shares of a company that also happens to be listed in Canada. For instance, Royal Bank is listed on both the Toronto Stock Exchange and the New York Stock Exchange. After you've bought Royal Bank's New York-listed shares, have your broker immediately transfer those shares over to the Canadian side of your account and sell them in Toronto for Canadian dollars. Voila, you've used Royal Bank shares as a bridging medium between U.S. dollar balances and Canadian ones.

These days, Norbert's gambit no longer requires a New York leg. Because the Toronto Stock Exchange conveniently lists a wide variety of U.S dollar-denominated securities, one can execute the gambit while staying entirely within the Canadian market. In my case, I used a fairly liquid Toronto-listed ETF as my temporary medium of exchange, the Horizon's U.S. dollar ETF, or DLR. I bought the ETF units with my excess U.S. dollars and sold them the very next moment for Canadian dollars.

Below I compare how much Norbert's gambit saved me relative to using my bank:

Using the ETF as a bridging asset, I converted US$5005 into C$6465, paid $19.90 in commissions, for a net inflow of $6,445.10 Canadian dollars into my account. Had I used my bank, I would have ended up with just $6265, a full $180 less than Norbert's gambit. That's a big chunk of change!

What is occurring under the hood? Norbert's gambit is providing a retail customer like myself with the same exchange rate that large institutions and corporations typically get i.e. the wholesale rate. Because there is a market for the DLR ETF in both U.S. dollar and Canadian dollar terms, an implicit exchange rate between the two currencies has been established. Call it the "Norbert rate". Large traders with access to wholesale foreign exchange rates set the Norbert rate by buying and selling the DLR ETF on both the U.S. and Canadian dollar side. If any deviation between the Norbert rate and the wholesale exchange rate emerges, they will arbitrage it away. Small fish like myself are thus able to swim with the big fish and avoid the awful retail exchange rate offered by Canadian banks.

This workaround is called Norbert's gambit after Norbert Schlenker, a B.C-based investment advisor who it to help his clients cut costs. Says Schlenker in a Globe & Mail profile:

"In 1986 I moved down to the States, and while I was there I needed to be able to change funds from U.S. dollars to Canadian and vice-versa, and I had a brokerage account in Canada. It came to me that I could use interlisted stocks to do this."

Thanks, Norbert!

But using stock as money isn't just a strange Canadianism. Back in 2014, I wrote about other instances of stocks serving as a useful medium-of-exchange. During the hyperinflation, Zimbabweans used the interlisted shares of Old Mutual to evade exchange controls, lifting them from the Zimbabwe Stock Exchange to London. Earlier, Argentineans used stocks (specifically American Depository Receipts) in 2001 to dodge the "corralito". But I never imagined I'd use this technique myself to skirt around Canada's banking oligopoly!

C-day and military money

 Did Indian PM Narendra Modi get the idea for the recently-executed demonetization by watching old episodes of M*A*S*H, a 1970s hit TV show set in the Korean War?

In the clip below, M*A*S*H's Colonel Potter is alerted to an imminent phasing out old "blue" military money with red, the idea behind the switch to punish counterfeiters and black marketers. As the conversion is happening, Colonel Potter is ordered to make sure that the gates to the base are closed so as to prevent illegitimate blue money from being smuggled in for changing. Sounds a bit like Modi's November 8, 2016 sudden phasing out of ₹1000 and ₹500 notes, no?



The money switch depicted in the M*A*S*H episode isn't just fiction. During the Vietnam War, mass demonetizations were a fairly common event on military bases. To isolate dollar-using U.S. troops and civilian contractors from the regular Vietnamese monetary system, U.S. military authorities fashioned a parallel scrip-based system in which Military Payment Certificates, or MPCs, displaced regular dollars as the medium of exchange on U.S. bases (see top for an example).

All troops arriving in Vietnam were required to convert their U.S. cash into MPCs at a 1:1 rate. Over the course of a tour, troops received a monthly MPC stipend which could be spent at the army store on things like cigarettes or Pentax cameras. Usage of certificates by local Vietnamese or by troops off-base was prohibited. At the end of their tour, troops would reconvert all MPCs back in to dollars at the 1:1 rate, since any MPCs brought back to the U.S. were useless.

Unsurprisingly, the rule prohibiting non-American usage of MPCs was ignored as Vietnamese retailers began accepting MPCs from American GIs in payment. This was seen as a bad thing by the U.S. military and Vietnamese government, since any spread of MPCs into the domestic economy would displace local currency (in Vietnam's case the piastre), hindering the goal of rebuilding the local economy. To counter dollarization, U.S. authorities would periodically carry out sudden cancellations of existing MPC, replacing them with a new issue of scrip so as to strand Vietnamese users. With all Americans being confined to base on conversion day , or "C-day", there was no way for locals to get U.S. soldiers to act as go-betweens for conversion. This ever-present threat of C-day should, in theory at least, slow down the dollarization of the Vietnamese economy.

The other reason for regularly cancelling and reissuing MPCs was to flush out U.S. troops engaged in black market activity.  All GIs were allowed to convert a fixed amount of old MPC on C-day, no questions asked. Unusually large conversion requests above that amount would be investigated by military police to ensure that this wealth hadn't been dubiously acquired. To avoid being investigated, a would-be black marketeer might choose to sacrifice their MPCs, thus losing a large amount of wealth. These periodic losses would drive up the costs, and attractiveness, of engaging in black market activity.

The success of these conversions depended on secrecy, since any leakage of an imminent C-day would cause unauthorized users of MPC to quickly convert their hoard into goods at the military store, or exchange them on the black market into piastre or regular dollars. According to Prugh, the first C-day on October 21, 1968 resulted in $276.9 million in certificates being converted, with $6.2 million going unaccounted for, presumably because they were in the hands of unauthorized persons. The next C-day occurred less than a year later, on August 11, 1969. In the next conversion on October 7, 1970, about 25% of recalled MPCs were not accounted for, according to this GAO document. The final C-day took place almost three years later on March 15, 1973.

There were all sorts of ways to game the scrip system. During their tour of duty, troops were allowed to exchange MPC into dollars and transfer that value home by money order, as long as this amount did not exceed the soldier's monthly stipend. To get around these limits, those holding excessive amounts of MPC could recruit others with spare sending capacity as 'straw men' to transfer money on their behalf. We saw this happening in India too. During the recent demonetization, each Indian was allowed to deposit ₹250,000 worth of demonetized notes during the 50-day conversion period, no questions asked. Those holding large amounts of rupees paid others under the table to make use of their shelter.

Another trick used by GIs was to have regular $100 bills mailed to Vietnam. A GI could sell these dollars to a local for MPC at a premium, says $110. Locals were willing to pay this premium because regular dollars, which couldn't be demonetized, offered them protection . The GI could then convert this $110 in MPC into $110 dollars upon departure (or by money order), thus earning $10 round-trip.

Modi's reasons for embarking on demonetization mirrors those of the Vietnam-era C-day. The U.S. military used conversions to encourage use of piastre among locals; Modi used it to encourage use of digital money. And both want to attack the black market. It is somewhat worrying, however, that the best historical analogue for Modi's demonetization comes from wartime. I do realize that the army has developed a number of technologies now in wide civilian use, including the internet, but as a general rule the mechanisms adopted to cope during wartime are probably not ideal for peacetime.

The MPC program died decades ago. Nowadays, regular cash circulates freely on U.S. army bases overseas. Interestingly, the military is making an effort to go cashless, due in part to the high cost of shipping banknotes and coin to distant war theaters. To help cut these costs, the Department of Defence used cardboard tokens, or "pogs", rather than metal coins in the recent wars in Iraq and Afghanistan.

Shipping US coins to Iraq/Afghanistan war-zones was costly. So the DoD printed cardboard 5-10-25¢ tokens, or "pogs": https://t.co/kDJcnwBLfD pic.twitter.com/YfmeVPpH75

— JP Koning (@jp_koning) April 10, 2017

The Department of Defence has also encouraged usage of the EagleCash card, a stored-value card. One thing is for sure: closed-loop digital money is a far more effective way than paper-based scrip for isolating an army from the domestic monetary system of the nation it is occupying.

Bringing back the Somali shilling

Somalia has long played host to one of the world's strangest monetary phenomenon, a paper currency without a central bank. I explored the idea of Somalia's "orphaned currency" more fully four years ago, but if you're in a rush what follows is the tl;dr version. Despite the fact that both the Central Bank of Somalia and the national government ceased to exist when a civil war broke out in 1991, Somali shilling banknotes continued to be used as money by Somalis. Over the years, Somalis also accepted a steady stream of counterfeits that circulated in concert with the old official currency, a state of affairs that William Luther explores in some detail here.

The story is worth revisiting because apparently Somalia's newly restored central bank is on the verge of re-entering the game of printing banknotes after a quarter century absence. With the help of the IMF, the Central Bank of Somalia (CBS) plans to issue new 1000 shilling banknotes, the introduction of higher denomination notes coming later down the road.

Old legitimate 1000 shilling notes and newer counterfeit 1000 notes are worth about 4 U.S. cents each. Both types of shillings are fungible—or, put differently, they are accepted interchangeably in trade, despite the fact that it is easy to tell fakes apart from genuine notes. This is an odd thing for non-Somalis to get our heads around since for most of us, an obvious counterfeit is pretty much worthless. The exchange rate between dollars and Somali shillings is a floating one that is determined by the cost of printing new fake 1000 notes. For instance, if a would-be counterfeiter can find a currency printer, say in Switzerland, that will produce a decent knock off and ship it to Somalia for 2.5 U.S. cents each (which includes the cost of paper and ink), then notes will flood into Somalia until their purchasing power falls from 4 to 2.5 U.S. cents... at which point counterfeiting is no longer profitable and the price level stabilizes.

Below is the long-term price of Somali shillings, which I've snipped from Luther's paper. You can see how the purchasing power of a 1000 shilling note has fallen to what Luther calculates to be the cost of producing a new banknote, around 4 cents. His chart goes up to 2013, but if you look at the IMF's most recent report on Somalia (see Figure 3) you'll see that the exchange rate hasn't moved much.

From Luther

So with a new official banknotes on the way, what will happen to the old legacy notes and counterfeits? According to the IMF mission chief Mohammed Elhage, the IMF is in the midst of trying to determine at what price it will convert old notes for new official ones. So rather than repudiating counterfeits, the normal route taken by central bankers, the CBS will buy them up and cancel them. It will have to offer a decent price too, say like 5 or 6 U.S. cents for each 1000 note. If it makes a stink bid, say 3 U.S. cents, Somalis may simply ignore the appeal to bring in their old currency and keep using the old stuff. Because the buyback decision validates the work of counterfeiters, it just seems wrong. However, keep in mind that for the last twenty-five years it has been counterfeiters who have been willing to take on the risk of providing Somalis with a very real service, the provision of a working paper medium of exchange.

There is another good reason for buying up old legacy notes and counterfeits and cancelling them. If the CBS lets the old notes stay in circulation, then Somalia's ragtag multi-currency system will only get more confusing, with old legacy and counterfeit notes circulating concurrently with new shillings and U.S. dollars. With the new issue of shillings having a different purchasing power than the old ones, yet another floating exchange rate will be added to the mix. Who needs that sort of confusion? Better for the CBS to absorb the cost of buying up fakes in order to promote a more homogeneous currency.

***

As I pointed out in my old post, there's an old and nagging question in monetary economics that has never been satisfactorily answered: why is fiat money valuable? Somalia serves as a great laboratory to investigate this question because its situation is so unique. One famous answer to the riddle of fiat money is that governments use force to ensure that fiat money is valued. But this can't be the case in Somalia: it hasn't had a government since 1991, yet shillings continue to be accepted.

A second answer is that once money is valued—say because it a central bank has been pegged to an existing store of value like gold—then once the central bank disappears and the anchor is lost, those orphaned notes will continue to have value by dint of pure inertia and custom. This theory certainly seems to fit Somalia's experience.

The last theory is that when a central bank is destroyed, the money it issues will quickly become worthless... unless citizens expect a future central bank to emerge and reclaim the orphaned currency as its own. If so, it makes sense to keep using the currency since it isn't actually orphaned—it's on the way to being adopted. If the expectation is that this future central bank will also adopt counterfeit notes, it makes sense for people to accept all knock-offs as well. So we can tell a story that shillings, both real and fake, never fell to zero because enough Somalis had a hunch that a future body would reclaim them, a hunch that is on the verge of being realized as a newly-christened CBS seems set to buy old and fake shillings back. Were Somalis really this good at predicting the future? I don't know, but like the second theory, the last one seems to explain the data.
 

***

Personally, I think introducing a new paper currency is a bad idea. For some time now Somalia has been partially dollarized economy. U.S. dollar banknotes are the most popular paper currency, with old shillings being used in small payments and in the countryside. Mobile payments are extremely popular, but they are usually denominated in U.S. dollars, not shillings, and tend to be prevalent in cities where network coverage is best.

There are several problems with dual-currency systems like Somalia's. First, they impose a small but steady stream of currency conversion costs on the population, both the actual cost of shifting one's wealth from one to the other as well as the mental gymnastics involved in converting prices in one's head. Secondly, there are fairness issues. Civil servants are usually paid in the domestic currency and those in rural parts deal in the stuff. Urban private sector workers tend to earn dollars. In developing nations, dollars are usually more stable than domestic currency. As a result prices of houses, cars, and rent are often set in dollars. The class of folks who are paid in dollars make out better than the class that is earning shillings. Dollar earners never have to leave the much stabler dollar loop while those earning domestic currency suffer from constant slippage due to conversion costs and chronic inflation.

Now the IMF might argue that new shillings will completely expel dollars, thus forcing everyone into the same shilling loop and removing any monetary inequalities. But that's hog wash. The literature on dollarization teaches us that once the dollar begins to be used by a country—usually because the domestic currency has suffered from high inflation—it is very hard to remove it. Long after the local currency has been successfully stabilized, dollarization continues, an effect referred to by economists as hysteresis. Bring back the shilling and the dollar will stick around.

While bringing back new shillings doesn't make much sense, some sort of currency reform is probably worthwhile. While cities seem to be already well-served by dollars and mobile money, the rural population still relies on old and deteriorating shilling notes. Instead of foisting new shillings on these people, why not replace them with locally-minted small denomination dollar coins? I call this the Panama solution. For those who don't know, Panama is a dollarized nation. Due to the high costs of shipping in coins form the U.S., Panama mints its own dollar-denominated small change, paper money printed by the Federal Reserve taking care of the rest of the nation's physical money requirements. 

By adopting the Panama model all Somalis would get to deal in U.S. dollars, thus removing any monetary class divisions. Gone too would be the headache of constantly converting between shillings and dollars, since with U.S. coinage there would only be dollars. And poor Somalians living in rural areas without phone coverage would finally get clean and homogenous small denomination cash.

Admittedly, there's far less for a central banker to do if he/she issues a narrow range of small denomination U.S. denominated coins, say 1¢, 5¢, and 25¢, rather than a full range of banknotes. It's certainly not sexy. But it would be cost effective. Coins, after all, last much longer than notes. This durability means that coins are a cheaper circulating medium for a central bank to maintain than paper. There is also the national ego that must be satisfied. What nation doesn't have its own currency? The worst reason to adopt a new shilling is because some concept of nationhood requires it—Panama has been using the dollar for decades, and this hasn't prevented it from becoming one of Central America's most successful nations.

Italian exit and the problem of lira shortages

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.

A 21st century U.S. trade dollar

"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 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 reasons 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.

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*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).

Don't kill the $100 bill

Last week I asked whether the Federal Reserve could get rid of the $100 bill. This week let's discuss whether it should get rid of the $100. I don't think so. The U.S. provides the world with a universal backup monetary system. Removing the $100 would reduce the effectiveness of this backup.

Earlier this week the New York Times took up the knell for eliminating high value bank notes, echoing Larry Summers' earlier call to kill the $100 in order to reduce crime which in turn was a follow up on this piece from Peter Sands. More specifically, Summers says that "removing existing notes is a step too far. But a moratorium on printing new high denomination notes would make the world a better place."

As an aside, I just want to point out that Summers' moratorium is an odd remedy since it doesn't move society any closer to his better place, a world with less crime. A moratorium simply means that the stock of $100 bills is fixed while their price is free to float. As population growth boosts the demand for the limited supply of $100 notes, their price will rise to a premium to face value, say to $120 or $150. In other words, the value of the stock of $100 bills will simply expand to meet criminals' demands. Another problem with a moratorium is that when a $100 bill is worth $150, it takes even less suitcases of cash to make large cocaine deals, making life easier—not harder—for criminals. To hurt criminals, the $100 needs to be withdrawn entirely from circulation, a classic demonetizaiton.

With that distinction out of the way, let's deal with three of the motivations for demonetizing high denomination notes: to reduce criminality, to cut down on tax evasion, and to help remove the effective lower bound.

Criminality

Summer's idea is to kill the $100 bill so that criminals have to rely on smaller denominations like $20s. Force criminals to conduct trade with a few suitcases filled with $20 bills rather than one suitcase filled with $100 bills and they'll only be able to jog away from authorities, not sprint. What sorts of criminals would be affected? The chart below (from this article by Peter Sands) builds a picture of cash usage across the different types of crime.

As the chart illustrates, the largest illegal user of cash is the narcotics industry. So presumably the main effect of a ban of $100s will be to raise the operating costs of drug producers, dealers, and their clients.

But should we be sacrificing the benefits of the $100 bill in the name of what has always been a very dubious enterprise; the war on drugs? An alternative way to reduce crime would be to redefine the bounds of punishable offences to exclude the narcotics trade, or at least certain types of drugs like marijuana. Law enforcement officers could be re-tasked to focus on the cash intensive crimes that remain, like human trafficking and corruption. In that way crime gets more costly and we get to keep the $100 to boot, which (as I'll show) has some very important redeeming qualities.

Tax Evasion

Cash is certainly one of the best ways to evade taxes, but there are other methods to reduce tax evasion. For instance, Martin Enlund draws my attention to a tax deduction implemented by Sweden in 2007 for the purchase of household related services, or hushållstjänster, including the hiring of gardeners, nannies, cooks, and cleaners. In order to qualify the services must be performed in the taxpayer’s home and the tax credit cannot exceed 50,000 SEK per year per person. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.*

Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to get their tax credits, many of these transactions would have been pulled into the open.

We can evidence of this in the incredible decline in Swedish cash demand ever since:

@t0nyyates @jp_koning Starting in July 2007 it became 50% cheaper to buy services (cleaning, ironing, baby-sitting) pic.twitter.com/4EHshRAHWR

— Martin Enlund (@enlundm) February 18, 2016

Sweden has the distinction of being the only country in the world with declining cash usage. The lesson here is that it isn't necessary to sacrifice the $100 in order to reduce tax evasion. Just design the tax system to be more lenient on those market activities that can most easily be replaced by underground production.

Escaping the lower bound

Yep, those advocating a removal of $100s are right. Central banks can evade the effective lower bound on interest rates and go deeply negative if they kill cash, starting with high denomination notes.

But as economists such as David Beckworth have pointed out, you can keep cash and still go deeply negative. All a central banker needs to do is adopt Miles Kimball's proposal to institute a crawling peg between cash and central bank deposits. This effectively puts a penalty on cash such that the public will be indifferent on the margin between holding $100 bills or $100 in negative yielding deposits.

Another way to fix the lower bound problem is a large value note embargo whereby the Fed allows its existing stock of $100 bills to stay in circulation but doesn't print new ones (much like Summers' moratorium). This means that if Yellen were to cut deposit rates to -2% or so, the price of the $100 would quickly jump to its market-clearing level, cutting off the $100 as a profitable escape route. As for the lower denominations, the public wouldn't resort to them since $20s are at least as costly to hold as the negative rate on deposits. Unlike Miles' proposal a large value note embargo doesn't allow for a full escape from the lower bound, but it does ratchet the bound downwards a bit, and it keeps the $100 in circulation.

Why should we keep it?

The $100 bill is the monetary universe's Statue of Liberty. In the same way that foreigners have always been able to sleep a little easier knowing that Ellis Island beckons should things go bad at home, they have also found comfort in the fact that if the domestic monetary authority goes rotten, at least they can resort to the $100 bill.

The dollar is categorically different from the yen, pound or euro in that it is the world's back-up medium of exchange and unit of account. The citizens of a dozen or so countries rely on it entirely, many more use it in a partial manner along with their domestic currency, and I can guarantee you that future citizens of other nations will turn to the dollar in their most desperate hour. The very real threat of dollarization has made the world a better place. Think of all the would-be Robert Mugabe's who were prevented from hurting their nations because of the ever present threat that if they did so, their citizens would turn to the dollar.    

I should point out that the U.S. gets compensation for the unique role it performs in the form of seigniorage. Each $100 is backed by $100 in bonds, the interest on which the U.S. gets to keep. So don't complain that the U.S. is providing its services as backup monetary system for free.

Foreigners who are being subjected to high rates of domestic inflation will find it harder to get U.S dollar shelter if the $100 is killed off; after all, it costs much more to get a few suitcases of $20 overseas than one case of $100. This delayed onset of the appearance of U.S. dollars as a medium of exchange will also push back the timing of a unit of account switch from local units to the dollar. As Larry White has written, money's dual role as unit of account and medium of exchange are inextricably linked. People will only adopt something as a unit of account after it is has already been circulating as a medium of exchange. A switch in the economy's pricing unit is a vital remedy for the nasty calculational burden imposed on individuals and businesses by high inflation. The quicker this tipping point can be reached, the less hardship a country's citizens must bear. The $20 doesn't get us there as quick as the $100.

So contrary to Summers, I think we should think twice before killing the $100. The U.S. has a very special to role to play as provider of the world's backup monetary system; it should not take a step back from that role. Criminals, tax evaders, and the lower bound can be punished via alternative means. I'd be less concerned about killing other high denomination notes such as the €500, 1000 Swiss franc, or ¥10,000. That's because inflation-prone economies don't euroize or yenify—they dollarize.


Addendum: If Summers is genuinely interested in combing the world of coins and bills for what he refers to as a 'cheap lunch', then there's nothing better the U.S. can do than stop making the 1 cent coin, which is little more than monetary trash/financial kipple. Secondly, replace the $1 bill, which is made out of cotton and supported by the cotton lobby, with a $1 coin. The U.S. lags far behind the rest of the world in enacting these simple cost cutting efforts.


*See here and here for more details on RUT and ROT avdrag,
** Martin Enlund has a great post here on Sweden's cash policies.

Euros without the Eurozone

This 2 euro coin is issued by Monaco, which is not a member of the Eurozone

Grexit isn't what people take it to be. The standard narrative is that Greece is approaching a fork in the road. It must either stay in the euro or adopt a new currency. I don't think this is an entirely accurate description of the actual fork that Greeks face. Over the next few months, Greece will either:

• A) stay a member in good-standing of the institution called the "Eurozone" and continue to legitimately use that institution's currency, the euro, or
• B) leave the Eurozone while continuing to use the euro 'illegitimately.'*

This means either the status quo of de jure (official) euroization or de facto (unofficial) euroization. In both cases, the euro stays.

The probability of a new drachma emerging is awfully low. The widespread idea that a sick country can rapidly debut a new currency and, more importantly, have that currency be universally adopted as a unit of account is magical thinking. Greece has been using the euro as a universal "language of exchange" for fifteen years. Switching over to a new unit is about as unlikely as Greeks suddenly beginning to speak German, network effects and all. Consider too the fact that Greeks don't want the drachma—they have consistently voted for euros. Syriza has no mandate to bring a new unit into existence. ***

Option B isn't an odd one. All sorts of countries 'illegitimately' piggy-back off the currencies managed by others. Zimbabwe, Ecuador, and Panama use the U.S. dollar without being card carrying members of the Federal Reserve System while Andorra, Kosovo, Montenegro, Monaco, San Marino, Vatican City use euros without being part of the Eurozone. Nor can the Eurozone can do anything to prevent de facto adoption of the euro by Greece. It's a decision that Greeks get to make themselves.

If Greece leaves the Eurozone on a de jure basis while staying a euro user, what will it be giving up?

The Greeks would NOT be losing the price stability and commonality already provided by Eurozone membership. These are presumably the features that lead most Greeks to declare in polls that they want to stay in the euro.

However, Greece would no longer get access to Eurozone lender of last resort facilities. One could argue that the nation would be better off without these facilities, given the discipline that a true 'no bailout' policy would enforce on both the banks and the government. Greece also loses direct access to the monopoly supplier of euro banknotes. A Greek banker can currently ask to have their Eurozone account be debited and a batch of freshly printed paper euros trucked over to their vault. Gone is that functionality. Panama has survived, even prospered, for decades without access to the Fed's discount window or Fed cash facilities.***

Greece would also lose its seat on the ECB Governing Council and therefore any say in determining monetary policy. Greece's one seat probably never gave it much influence anyways, especially compared to Germany's dominant influence in ECB decision making. Nor would Greek data be considered as an input into Eurozone policy decision should Greece leave. However, as it clocks in at just 2% or so of the Eurozone's total size, Greece's data could never have had much influence on the aggregates that ECB policy makers watched to begin with. Official user of euros or unnoffical, Greece will always lack an independent monetary policy.

Another concern is that Greece might not be allowed to use the ECB's Target2 real time settlement mechanism anymore. However, Denmark, Bulgaria, Poland, and Romania all connect to Target2, despite not being Eurozone members. Surely Greece would qualify. If not, it wouldn't be too complicated for Greek banks to set up their own payments system.

Lastly, Greece would forfeit all seigniorage revenues. Eurozone members currently get a share of the profits that the ECB earns on its monetary monopoly. I don't see this loss as being a big deal. Seigniorage has long since been eclipsed by taxes as the key source of a modern government's revenue.

The upshot is that whether Greece remains a legitimate member of the Eurozone or an unofficial user of the Eurozone's chief monetary product, the implications are about the same. There is no fork in the road, at least not from a monetary policy perspective; just a continuation of the same euro path as before.

I've left two features out. If Greece leaves, the claims and liabilities it has on the Eurozone must be unravelled and settled. Having invested around 200 million euros in the ECB when it was formed, Greece would have to be bought out by remaining Eurozone members at a reasonable price. Counterbalancing this would be Greece's obligation to unwind the debt that it has amassed to the Eurozone in the interim. This debt, known as its Target2 deficit, currently clocks in at around 100 billion euros, far in excess of the capital it is owed. It would take an incredible outlay of resources to pay this amount off. The advantage to the Greek population of staying in the Eurozone is that their debt need never be settled. After all, Target2 debts are by nature perpetual. Only by leaving do they face a final day of reckoning.

However, if Greece puts little-to-no cost on squelching on its debts, it may as well just leave the Eurozone without paying back the 100 billion it owes. It gets to continue to ride piggy-back on top of the euro, enjoying (almost) all the same benefits of being a Eurozone member, without being on the hook for anything. Why not perpetually bum cigarettes rather than pay for them?

Which is why Greece has a certain degree of power over the remaining Eurozone members. Should it shrug and leave, the remaining members are on hook for its unpaid tab. And once Greece goes down the de facto euroization path, how long before the next largest debtor to the rest of the Eurozone decides to shrug and leave? As Nick Rowe says, the last one holding a common currency is the sucker since they'll be left with everyone's bad debts. To keep the system going, the Euro project's architects need to do their best to ensure that Greeks aren't incentivized to just shrug and bum a free ride on the euro. I don't envy them their task, it's a difficult one.

The other aspect I've left out is the Greek banking system, which is probably insolvent. Once cutoff from the central bank that prints the stuff, Greek banks simply wouldn't be able to meet the rush to convert deposits into euro banknotes. The only way to return the banking system to functionality would be to chop the quantity of Greek bank deposits down to size so that the banks' asset base would be sufficient to absorb the run into cash. We're talking a multi-billion euro "bail-in" of depositors. The prospect of such a hit certainly tilts the decision between A and B back towards A.**


* Having been cut off from additional ECB lending, one might argue that Greece has already gone halfway towards exiting the Eurozone.
**  Paragraph added July 2.
*** Added cash facilities on July 2.
**** Added last two sentence to this paragraph on July 3.
Note: apologies for the constant additions, but this subject is complex and the situation getting more complex by the day, so rather than writing two or three posts I'm adding bits to the original.

The dollarization of bitcoin

Bitcoin was supposed to result in the bitcoinization of the world; instead, I'd argue that the world of bitcoin is being dollarized.

A successful medium of exchange will be used by four types of actors: retailers, consumers, financial intermediaries, and speculators. In bitcoin's case, the inherent volatility of the cryptocurrency militates against its adoption by anyone other than speculators, leaving dollars as the default option.

Let's start with the first bit of the equation; retailers, or merchants. Entrepreneurs who have been trying to bring bitcoin to the mainstream have discovered that while merchants like the idea of allowing consumers to pay with bitcoin, the merchants themselves refuse to deal in the stuff. Instead, upon receipt of bitcoin, a merchant's bitcoin payments processors—usually an intermediary like Bitpay or Coinbase—will instantly convert bitcoin into U.S. dollars on behalf of the merchant. Retailers choose to dollarize rather than bitcoinize because they are afraid of bitcoin's volatility, and justifiably so.

The next bit of the equation is the consumer. I argued in my previous post that it is dubious whether paying in bitcoin offers mainstream consumers any benefits relative to dollar payments. People who buy with bitcoin must incur added costs in the form of trading fees if they wish to move from dollars into bitcoin. They must also bear the burden of bitcoin's volatility until the moment of making a purchase.

To drive mainstream consumer adoption of bitcoin, those intermediaries who are servicing buyers will have to begin offering the same sort of volatility-shielding services that bitcoin payments providers currently offer to merchants. A permanently shielded wallet, for instance, would allow consumers who want to make a purchase the opportunity to store value in U.S. dollar terms until the very last moment, at which point the intermediary takes on the bitcoin risk and consummates the deal. Of course, this only pivots things further towards dollarization, not bitcoinization.

The inevitable product that emerges will be a just-in-time bitcoin solution. Buyers have the benefits of holding dollars up until the moment at which they press the Buy Now button, at which point the intermediary takes over and sells their dollars for bitcoin. The switching of the payment from the dollar rails onto the bitcoin rails is only momentary. Upon receipt of the bitcoin payment an instant later, the merchant's payments provider will immediately sell the bitcoin and deliver dollars to the merchant. With both buyer and seller choosing to dollarize, neither has to suffer from bitcoin's volatility. However, they still get to enjoy whatever cost savings are provided by rapid just-in-time usage of the bitcoin rails. Only speculators and intermediaries, who have now taken on the responsibility of dealing in bitcoin from consumer and retailers, have avoided dollarization.

But hold on. If all parties to the transaction only want dollars, why not just cut bitcoin entirely out of the equation? Instead of a just-in-time swap of bitcoin, the intermediaries involved—the buyers' bitcoin wallet provider and the merchant's bitcoin payments processor—can get together and agree to exchange a dollar IOU instead, saving them the hassle of dealing in bitcoin. Gone are the exchange fees, the obligation to pay bitcoin's bid-ask spread, and slippage that might occur if bitcoin's price weaves dramatically as the transaction is going through. To spare readers the gritty details, the footnote below describes how bitcoin intermediaries might fashion a U.S. dollar IOU trading network.

This puts these bitcoin intermediaries in the rather odd position of no longer being part of the bitcoin universe. Instead, intermediaries have become like interlinked Paypals, offering U.S. dollar accounts to consumers and U.S. payment solutions to merchants.

Thus, in an effort to promote mass adoption of bitcoin, we've somewhat perversely arrived at the opposite, an all-out dollarization of what was supposed to be a bitcoin retail payments network. Buyer and merchant hold only dollars, and so-called bitcoin intermediaries like wallets and payments processors no longer deal in the stuff. That leaves only speculators to hold the bitcoin bag. This system of individual PayPals will be built on top of the very infrastructure that bitcoin was designed to tear down, namely the existing dollar rails run by incumbent banks and underpinned by the Federal Reserve.

This isn't to say that bitcoin is a failure as a retail payments option. But I have troubles seeing it ever going mainstream.  Even if bitcoin continues to exist as an arcane niche payments system for a community of like minded consumers and retailers, that's still constitutes quite a success, albeit one that has not lived up to many people's dreams.

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In writing this, I stumbled on an earlier post by Guan that already arrived at a similar conclusion. If you've already read his post, my apologies for wasting your time and making you read mine.

The gritty details: Rather than trading bitcoin to settle payments between consumers and retailers, intermediaries can simply trade dollar IOUs. Costs should be lower than settling in bitcoin. To begin with, bitcoin intermediaries will have to maintain U.S. dollar clearing accounts with all the other bitcoin intermediaries. Over the course of a trading period, dollar payments will flow into an out of these clearing accounts. At the end of the day, each intermediary's account will be netted and cleared against all other intermediaries' accounts. The result is that some intermediaries will be owed dollars, others will owe. These balances will all be settled that very evening on the books of an underlying commercial bank, say Citi, where all intermediaries also maintain accounts. Since accounts are settled on the books of Citi, intermediaries needn't incur expensive inter-bank wire transfer fees. Citi has, in effect, become the central bank for a bitcoin based payments system, sans the bitcoin.

Grexit: An Escape to More of the Same

The upcoming Greek election has renewed interest in the idea of Grexit. This option is often presented to the Greek public as desirable given that it would restore an independent monetary policy to the nation.

Beware, this is dangerous advice. The euro isn't a glove that you can take on and off, it's a Chinese finger trap; once in, it's tricky to get out. Even if Greece were to formally leave the euro, odds are that it would remain unofficially euroized, leaving it just as bereft of an independent monetary policy as before. The real trade off in a Grexit-or-not scenario is between formal membership in the euro with some say in monetary policy, no matter how small, or informal membership without any say whatsoever.

The optimists, say someone like Hans-Werner Sinn, advise the Greeks to leave the euro and adopt a new currency. The value of this new drachma would immediately collapse. As long as prices in Greece are somewhat sticky, Greek goods & services will become incredibly competitive on world markets, spawning an export/tourism-led recovery. By staying on the euro, however, Greece forfeits the exchange rate route to recovery. Instead, Greece's competitiveness can only be restored via a painful internal devaluation as wages and prices adjust downwards.

While the optimists tell a good story, they blithely assume a smooth switch from the euro to the drachma. Let's run through the many difficult steps involved in de-euroization on the way to an independent monetary policy. All euro bank deposits held at Greek banks must be forcibly converted into drachma deposits, and speedily enough that a bank run is preempted as Greeks desperately try to evade the corral by moving euros to Germany. At the same time, the Bank of Greece, the nation's central bank, needs to issue new drachma bank notes, the public being induced to use these drachmas as a medium of exchange.

Now even if Greece somehow pulls these two stunts off (I'm not convinced that it can), it still hasn't guaranteed itself an independent monetary policy. To do so, the drachma ₯ must also be adopted as the unit of account by the Greek public. Not only must financial markets like the Athens Stock Exchange begin to publish stock prices in drachmas, but supermarkets must be cajoled into expressing drachma sticker prices, employees and employers need to set labour contracts in terms of drachmas, and car dealership & real estate prices need to undergo drachma-fication.

Consider what happens if drachmas begin to ciruclate as a medium of exchange but the euro remains the Greek economy's preferred accounting unit. No matter how low the drachma exchange rate goes, there can be no drachma-induced improvement in competitiveness. After all, if olive oil producers accept payment in drachmas but continue to price their goods in euros, then a lower drachma will have no effect on Greek olive oil prices, the competitiveness of Greek oil vis-à-vis , say, Turkish oil, remaining unchanged. If a Greek computer programmer continues to price their services in euros, the number of drachmas required to hire him or her will have skyrocketed, but the programmer's euro price will have remained on par with a Finnish programmer's wage.

As long as a significant portion of Greek prices are expressed in euros, Greece's monetary policy will continue to be decided in Frankfurt, not Athens. Should the ECB decide to tighten by lowering interest rates, then Greek prices will endure a painful internal deflation, despite the fact that Greece itself has formally exited the Euro and floated a new drachma.

We know that a unit of account switch (not to mention successful introduction of drachma banknotes) will be hard for Greece to pull off by looking at dollarized countries in Latin America. To cope with high inflation in the 1960s and 70s, the Latin American public informally adopted the U.S. dollar as an alternative store of value, medium of exchange, and unit of account. Even after these nations' central banks had succeeded in stabilizing their own currencies, however, dollarization proved oddly persistent. This is referred to as hysteresis in the economics literature. Economists studying dollarization suggest that network externalities are the main reason for hysteresis. When a large number of people have adopted a certain standard there are significant costs involved in switching over to a competing standard. The presence of strong memories of past inflation may also explain dollar persistence.

In trying to de-euroize, Greece would find itself in the exact same shoes as Latin American countries trying to de-dollarize. Greeks have been using the euro for 15 years now to price goods; how likely are they to rapidly switch to drachmas, especially in light of the terrible performance of the drachma relative to other currencies through most of its history? Those few Latin American countries that have successfully overcome hysteresis required years, not weeks. If Greece leaves the euro now, it could take decades for it to gain its own monetary policy.

As an alternative illustration of the power of network externalities, consider the multi-year plans made by Slovakia (pdf, fig 2) prior to switching over to the euro, or the Czech Republic's timeline when it makes the changeover. Each step must be broadly communicated and telegraphed long ahead of time so as to ensure that all members of a nation are properly coordinated, thus ensuring the network effects engendered by the incumbent currency can be overcome. These euro changeover plans weren't adopted a few days before the switch, but often as much as a decade before.

In sum, I fail to understand how Greece can ever expect to enjoy the effects of a drachma-induced recovery if the odds of drachma-fication or so low, especially given the sudden nature of a Grexit. At least if it stays part of the euro, Greece has a say in how the ECB functions thanks to the Bank of Greece's position in the ECB Governing Council. And at least Greece's inflation rate and unemployment rate will be entered into the record as official data worth considering by ECB monetary policy makers. For just as the Federal Reserve doesn't consider Panamanian data when it sets monetary policy (Panama being a fully dollarized nation), neither would the ECB care about Greek data if Greece were to leave the euro, though still be euroized.

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Basil Halperin responds.

More monetary lunacy from Mugabe

In a recent speech leading up to an end-of-month national election, Zimbabwe's President Robert Mugabe hinted at the possibility of introducing a gold-backed Zimbabwe dollar.

This is from the Mail & Guardian:

Then there is the business about the Zim dollar, that one issue that makes every Zimbabwean wake up in a cold sweat, and one that every candidate should really avoid. We cannot use the US dollar forever, he [Mugabe] begins. We will have to look at ways of bringing back our currency, sometime in the future. There are uncomfortable murmurs. Mugabe appears to be thinking out loud. "Should we, should we not?" he asks himself. "What if we back our currency with all our gold? Wouldn't it be strong enough? Maybe not now, of course, but sometime in the future. Maybe we will talk to [Gideon] Gono, the Reserve Bank governor."

I'm sure the memories of the hyperinflation are too fresh in the minds of Zimbabweans for them to buy into the folly of letting the insane duo of Mugabe and his central banker, Gideon Gono, once again have their own printing press, even if that press is to be constrained by gold convertibility. Let's take a quick glance through the 2007 Reserve Bank of Zimbabwe (RBZ) annual report [link] for a refresher of what the two of them got up to the last time around. By then in the midst of a severe hyperinflation, the RBZ's 2007 report kicks off with a boilerplate disavowal of any responsibility for the plunge in the Zim dollar's purchasing power, blaming it on "supply side constraints, speculative activities, and adverse expectations."

The report goes on to describe a dizzying number of "support" programs set up by the RBZ. These include in no particular order:

A) Farm Mechanization Program: to provide farmers with the funds to purchase tractors, combines, plows, and sprayers.
B) Agricultural Sector Productivity Enhancement Facility: to provide low cost funds to support producers of beef, pigs, and poultry
C) Parastatals Reorientation Program: aid to suffering government-owned businesses including Cold Storage Co of Zimbabwe, Tel One, and Net One.
D) Basic Commodities Supply-Side Intervention Facility: targeted financial support to ensure a quick return of basic goods to supermarket shelves
E) Tourism Development Facility: funds for hotels, lodges, and tour operators
F) Seed Development Program: funding to procure maize, soybean, and sorghum seed
G) National Cattle Herd Restocking Program: the purchase of breeding cattle for onlending to farmers
H) Rural Business Facility: funds for rural retailers including hardware shops, wholesalers, and butchers.
I) and more...

A large quantity of the support provided via these RBZ programs went straight to Gono and Mugabe's friends and allies. Coincidentally, it would seem that Gono, while RBZ governor, has become one of the biggest chicken farmers in Zimbabwe, recently boasting in the press that he expects to be Africa's first chicken-farming billionaire. Even if Gono didn't fund his farming dreams by diverting funds from RBZ agricultural support programs to himself, his suppliers, or purchasers, the conflict of interest presented by Gono's twin roles as chicken farmer and chicken farm financier is breathtaking. It would be like putting Jamie Dimon in charge of the Fed, without requiring Dimon to resign from and sell his shares in JP Morgan.

Most of the RBZ's special lending programs, as well as the direct financing of the government carried out by the RBZ, were granted at rates far cheaper than the market rate. Whenever a central bank keeps its rate perpetually below the market rate, hyperinflation is the inevitable result. But in Gono and Mugabe's Alice in Wonderland world, their so-called support programs weren't the cause of the hyperinflation, but rather the cure to hyperinflation. How did the pair square this very odd circle? Here is Gono explaining the Farm Mechanization Program:

Many may wonder why Your Central Bank gets involved in some of these activities which, on the face of it, appear to be outside our core mandate of inflation fighting. Your Excellency, inflation remains our number one enemy and core business. Thirty three percent (33%) of that inflation relates to Food and Food items alone. It follows therefore that our attempts to boost agricultural productivity in collaboration with Government and other stakeholders is actually an ancillary and incidental part of our core business.

According to Gononomics, inflation is not something created by a central bank but an external enemy that must be fought. The RBZ's cheap loans to the farm sector didn't set off inflation, but rather they improved productivity and reduced food prices, thereby reining in inflation. Reality, of course, had something stern to say about this. The Zim dollar continued to plunge in value, eventually hitting zero a year after Gono's speech. Gono and Mugabe were appropriately stripped of their printing press by the course of events, and that is how the situation should stay.

I'll deal with a few reasons that might be put forward for the resurrection of the Zim dollar, and why these reasons are not sufficient to counterbalance the danger of giving our two hyperinflationistas their own currency.

1) First, many people complain of a "small change" problem in Zimbabwe. A paucity of US dollar coins in circulation means that it is difficult for someone purchasing, say, $1.85 worth of food with $2.00 to get back 15c in change. While we in the West might consider change to be an inconvenience -- it is heavy and clinks around -- in a country like Zimbabwe where the average daily income is only a few dollars, the lack of coinage is a major problem.

This is hardly an issue that needs to be solved by a new Gono dollar, though. One route that Zimbabwean shopkeepers have taken to make things easier is to provide change in by the form of gum, candy, or other small items. This isn't an ideal solution, but it is a start of sorts. Private bus owners give change in the form of coupons that can be redeemed for transportation at some later date. These coupons don't appear to be highly liquid, though. The South African five rand coin has been recruited to serve the role of a 50 cent piece, regardless of the actual exchange rate between rand and US dollars. This is fine for now, but as the USD-ZAR exchange rate changes over time, the use of rand coins as change in US dollar transactions may become computationally burdensome.

A better solution would be to allow private Zimbabwean banks to coin or print 10c, 25c, and 50c tokens/coupons that, when brought back to the issuing bank, might be converted into their dollar equivalent. This would require the regulatory blessing of the RBZ. The RBZ, unfortunately, seems to be extremely jealous of those who would print or coin currency. In a bizarre story from this spring, two "prophets" claimed to be able to create US dollars from scratch, those in their audience reportedly receiving "miracle money" in their pockets. Gono immediately investigated the duo, eventually clearing them of any wrongdoing. If so-called miracle money receives such scrutiny from the RBZ, one can be sure that bank-produced small change would have to jump through incredibly high hoops before being permitted.

Lars Christensen has also discussed the small change problem in Zimbabwe, noting the potential for e-money to fill the gap. I won't go into any depth on this possibility since Lars has covered it in some detail.

2) A second purported reason for introducing a new Zim dollar is to provide for the lender of last resort. Since the RBZ can't print US dollars willy nilly, Zimbabwe banks can't turn to their nation's central bank when they need liquidity support.

We've grown so used to the idea of a lender of last resort that we rarely stop to consider that such a lender is not a necessary feature of an economy. Panama has been effectively dollarized since 1904 and for that entire time has been without a lender of last resort. Panamanian banks have adapted by holding relatively high levels of liquid assets as self-insurance [link]. Bank failures have been small and infrequent, with the only major crisis event being related to the Manuel Noriega incident in the late 1980s. [link]

Like Panamanian banks, Zimbabwean banks will adapt to the lack of lender of last resort by modifying their own banking practices to ensure that their balance sheets are sufficiently flexible to deal with liquidity crisis.

In sum, Zimbabwe's currency situation is better than it has been in years and will only improve as technologies and practices evolve to deal with the small change problem, and as banks position themselves to deal with potential liquidity shortfalls. A Mugabe/Gono attempt to bring back the Zim dollar, whether it be gold-backed or not, is thoroughly unnecessary. Should the duo succeed in linking a new currency to gold, it is probable that they'll quickly close the gold window in order to get back to their old ways,  a scenario that no one wants. With any luck, Zimbabweans will throw the scoundrels out onto the street come election time. Mugabe and Gono certainly deserve it.