Tuesday, June 20, 2017

The road to sound digital money


No, I'm not talking about sound money in the sense of having a stable value. I'm talking about money that is sound because it can survive natural disasters, human error, terrorist attacks, and invasions.

Kermit Schoenholtz & Stephen Cecchetti, Tony Yates, and Michael Bordo & Andrew Levin (pdf) have all recently written about the idea of CBDC, or central bank digital currency, a new type of central bank-issued money for use by the public that may eventually displace banknotes and coin. Unlike private cryptocoins such as bitcoin, the value of CBDC would be fixed in nominal terms, so it would be very stable—much like a banknote.*

It's interesting to read how these macroeconomists envision the design of a potential CBDC. According to Schoenholtz & Cecchetti, central banks would provide "universal, unlimited access to deposit accounts." For Yates this means offering "existing digital account services to a wider group of entities." As for Levin and Bordo, they mention a similar format:
"Any individual, firm, or organization may hold funds electronically in a digital currency account at the central bank. This digital currency will be legal tender for all payment transactions, public and private. The central bank will process such payments by debiting the payer’s account and crediting the payee’s account; consequently, such payments can be practically instantaneous and costless as well as completely secure."
I don't want to pick on them too much, but all these authors are describing a particular implementation of central bank digital money: account-based digital money. There's an entirely different way to design a CBDC, as digital bearer tokens. My guess is that the authors omit this distinction because macroeconomists tend to abstract away from the differences between various types of money. Cash, coins, deposits, and cheques are all just a form of M in their equations. But if you get into the nitty gritty, bearer tokens and accounts two are very different beasts. Some thought needs to go into the relative merits and demerits of each implementation, especially if this new product is to replace banknotes at some hazy point in the future.

Let's first deal with account money. An owner of account-based money needs to establish a connection with the central issuer every time they want to make a payment. This connection allows vital information to flow, including instructions about how much money to transfer and to whom, confirmation that there is sufficient funds in the owner's account, and a password to confirm identity. Only then can the issuer dock the payor's account and credit the payee.

Bearer money, the best examples of which are banknotes and coins, never requires a connection between user and issuer. As I described in last week's post, courts have extended to banknotes the special status of having"currency." What this means is that if you are a shopkeeper, and someone uses stolen banknotes to buy something from you, even if the victim can prove the notes are stolen you do not have to give them back. The advantage of this is that there is never any need for a shopkeeper to call up the issuer in order to double check that the buyer is not a thief.** As for the issuer, say a central bank, they are not responsible for the debiting and crediting of banknote balances, effectively outsourcing this task to buyer and sellers who settle payments by moving banknotes from one person's hand to the other. The upshot of all this is that since users and issuers of bearer money don't need to exchange the sorts of information that are necessary for an account-based transaction to proceed, there is no need to ever link up.

This makes bearer money an incredibly robust form of money. If for any reason a connection can't be established between user and issuer, say because of a disaster or a malfunction, account-based money will be rendered useless. Examples of this include the recent two-day outage of Zimbabwe's account-based real-time gross settlement system due to excess usage, or the famous 2014 breakdown of the UK's CHAPS, its wholesale payments system, which limited the system to manual payments. M-Pesa, Kenya's mobile money service, has periodic outages, and last month my grocery store, Loblaw, suffered from a malfunction in its debit card system. Banknotes—which don't require constant communication with the mothership—worked fine throughout.

The private sector used to be heavily engaged in providing bearer money, both in the form of banknotes and bills of exchange. However, bills of exchange-as-money went extinct by the early 1900s. As for banknotes, the government thoroughly monopolized this activity by the mid-1900s. Which means the government has—perhaps inadvertently—taken on the mantle of being the sole issuer of stable, disaster-proof money. So any plan to slowly phase out government paper money is simultaneously a plan to phase out society's only truly robust payments option.

Going forward, it's always possible that governments once again allow the private sector to  issue bearer money. With the government's bearer money monopoly brought to an end, the public would be well-supplied with the stuff and central banks could safely exit the business of providing a robust payments option. But I can't see governments agreeing to relinquish this much control to private bankers. Which means that for society's sake, whatever digital replacement central banks choose to adopt in place of banknotes and coins should probably have bearer-like capabilities in order to replicate cash's robustness. Account-based money won't cut it. Nor will volatile private tokens like bitcoin.

One way to design a digital bearer money system is to have a central bank issue tokens onto a distributed ledger and peg their value, say like the Fedcoin idea. The task of verifying transactions and updating token balances would be outsourced to thousands of nodes located all over the world. So if all the nodes in the U.S. have been knocked out, there will still be nodes in Europe that can operate the payments system. This would restore a key feature of banknotes, that they have no central point of failure, thereby allowing central banks to get rid of cash. I'm sure there are other ways of creating robust money than using a distributed ledger, feel free to tell me about them in the comments section.



* CBDC would be redeemable on a 1:1 basis for traditional central bank money (and vice versa), so the two would have the same value and be interchangeable. Consumer prices, which are already expressed in terms of traditional central bank money, would now also be expressed in terms of CBDC. Since consumer prices tend to be sticky for around four months, CBDC holdings would have a long shelf-life. If CBDC was designed like bitcoin--i.e. its quantity was fixed and there was no peg to existing central bank money--then its value would diverge from traditional central bank money. Price would continue to be expressed in terms of traditional central bank money, and would be sticky, but there would be a distinct CBDC price that would no longer be sticky. So CBDC would no longer have a long-shelf life; indeed, CBDC prices could become quite volatile. See here.
** The caveat here is that while banknotes have long since been granted currency, CBDC—which does not exist—has not. Nor have cryptocurrencies like bitcoin been granted currency status. But if a central bank were to issue a bearer form of CBDC, it's hard to imagine the courts not declaring it to be currency fairly early on, unlike say bitcoin.

PS: I just stumbled on a 2006 paper from Charles Kahn and William Roberds which nicely captures these two types of money:


Saturday, June 17, 2017

On currency


David Birch recently grumbled about people's sloppy use of the term legal tender, and I agree with him. As Birch points out, what many of us don't realize is that shopkeepers have every right to refuse to accept legal tender such as coins and notes. This is because legal tender laws only apply to debts, not to day-to-day transactions. If someone has borrowed some money from you, for instance, then legal tender laws dictate a certain set of media that you cannot refuse to accept to settle that debt. These laws have been designed to protect your debtor from a situation in which you demand payment in a rare medium of exchange, say dinosaur bones, effectively driving them into bankruptcy.

Conversely, they also protect you the lender from being paid in an inconvenient settlement medium. In Canada, for instance, a five cent coin is legal tender, but only up to $5. If your debtor wants to pay off a $10,000 debt using a truckload of nickels, you can invoke legal tender laws and tell them to screw off—give me something more convenient.

Joining in with Birch in the grumbling, I'd argue that people make just as many errors with the term currency as they do with legal tender. When we use the word currency, we typically mean a grab bag of paper money, coins, deposits, and cryptocurrencies, or we use it to describe national units of account such as dollars, yen, pounds, pesos, ringgits, bitcoin, etc. But the word currency shouldn't be used so sloppily. 

Henry Dunning Macleod, a monetary theorist who wrote in the 1800s, has an interesting discussion of the etymology of the word. Macleod was a unique character in his own right. Trained as a commercial lawyer, he signed up as director of the Royal British Bank which failed in 1856 due to questionable loans and self dealing. Macleod went on to write a number of large tomes on monetary theory,  history, and law, including the Elements of Economic, on which I am drawing from for this post. Perhaps his main contribution to economics is the coining of the term Gresham's law, according to George Selgin.

From Macleod we learn that currency used to be used an adjective, not a noun. Certain types of goods or instruments were considered to be "current" in the eyes of the law and common business practice. They were said to have "currency," but were not themselves currency. Here is a clip from his book:
Let's break this down. Property that had been granted currency had a different legal status from property that didn't. Let's assume that a good has been stolen and sold by the thief to a third party, a shopkeeper, who innocently accepts it not knowing that it has been stolen. For most forms of property the original owner could sue the third party and get the stolen article back. But not if that good is one of the few to be considered by society to have currency, wrote Macleod. When an article is said to have currency, or to be current, the original owner cannot chase the third party to recover stolen property. So in our example, our shopkeeper gets to keep the stolen good, even if its stolen nature has been proven in court.

Coins had always been current according to mercantile practice, but if you read through Macleod you'll see that over the course of the 1700s, British common law jurists granted currency status to a series of new financial instruments, including banknotes, bills of exchange, stock certificates, exchequer bills, bonds, and more. (I went into this here.) What this illustrates is that an item didn't have to be money to have currency (e.g. bonds were considered to be current), nor did it have to be government-issued to be current (banknotes and bills of exchange were privately-issued).

Granting currency-status to a select group of instruments provided them with some useful mercantile properties. Consider first the converse: when the law did not grant currency to a certain good, any transfer of that good came with strings attached. For instance, if you tried to pawn off an expensive gold ring on a shopkeeper, the possession of that ring in your pocket would not be sufficient for the shopkeeper to establish title. If the ring had been stolen, and he/she accepted it, the shopkeeper might be forced to give it back to its original owner, leaving the shopkeeper out of pocket. So they would be wary at the outset about accepting the ring from you, perhaps requiring a time-consuming verification process before agreeing to the deal.

On the other hand, the shopkeeper would not hesitate to accept a gold coin. Because coins were current according to the law, anyone who received them in trade would not have had to worry about returning them to an angry victim down the line, and therefore could avoid the necessity of setting up a costly verification procedure. This would have encouraged trade in these instruments, rendering them much more liquid than items that weren't current.

According to Macleod, it was only after these early court cases that people started to directly refer to banknotes, coin, yen, dong, pounds, krona, and the like as currency-the-noun, a linguistic switch which Macleod angrily blamed on Yankee "barbarism":
"It is quite usual to say that such an opinion or such a report is Current: and we speak of the Currency of such an opinion or such a report... But who ever dreamt of calling the report or the opinion itself Currency?... To call Money itself Currency, because it is current, is as absurd as to call a wheel a rotation, because it rotates...Such as it is, however, this Yankeeim is far too firmly fixed in common use to be abolished."
It is interesting to note that while not all instruments that had currency were money (i.e. bonds), likewise not all money was granted currency status. According to Macleod, bank deposits did not have currency because, unlike banknotes and coins, deposits could not be dropped in the streets, stolen, lost or transferred to someone else by manual delivery. If you think about it, each movement of a bank deposit requires direct contact with the banking system in order to process the transfer. This effectively weeds out transfers of lost or stolen property, especially in Macleod's day where banking was conducted in person at a branch. Since anyone receiving bank deposits in payment needn't worry about a deposit being dubious, there was no need for the law to grant currency status to deposits.

All of this still has relevance today. Take the case of private cryptocurrencies, ICOs, and central bank digital currencies (CBDC). Because law makers have not been very clear about their legal status, bitcoin and other forms of crypto don't have currency, at least not in the Macleodian sense of the term. This means that a storekeeper who accepts bitcoin (or a future Fedcoin) may also be taking on the liability to give said coins back if they are proven to be stolen. And this lack of currency-status can only handicap a cyptocoin's ability to freely circulate.

If this post achieves anything, it's to illustrate that a special amnesty was once granted to a small set of financial instruments. This amnesty used to be referred to as currency. While we don't have to go back to the old practice of using of the word currency to refer to this special amnesty, we should at least be aware that this amnesty is still present and relevant.

Friday, June 9, 2017

The forking of the Indian rupee


This post is about the dismantling of the rupee-zone between 1947-49, an historical event that is especially topical in light of two modern monetary projects: Narendra Modi's poorly-executed 2016 demonetization and a potential eurozone breakup.

Thanks to a recommendation by Amol Agrawal, who blogs at the excellent Mostly Economics, I've been pecking away at the 900-page history of the Reserve Bank of India, although I have to confess that I've spent most of my time on the chapter on the partition period. For those who don't know, India and Pakistan weren't always independent countries. Up until partition in August 1947, each was part of British India, a British colony. The rupee, which was issued by the Reserve Bank of India (RBI), was the sole medium of exchange in British India. By mid-1949, less than two years after partition, usage of RBI-issued rupees had been successfully limited to the newly-created state of India. As for Pakistan, it had managed to erect its own central bank, the State Bank of Pakistan, as well as introduce a new currency, the Pakistani rupee.

At the time of partition, Pakistan's architects faced a daunting challenge; given that the Brits had announced in early 1947 that the partition of British India was to occur that August, there remained only a few months to create a central bank and issue a new currency. Because printing enough new currency for an entire nation would take far more than a few months to achieve, a temporary solution was arrived at: to use the RBI as an interim agent for issuing currency until the new Pakistani central bank had its own printing presses up and running.

This "bridge" involved using a combination of regular RBI-issued rupees circulating within Pakistan at the time and "overprinted" notes issued by the RBI. To ensure that the purchasing power of the two rupees stayed locked, the overprints were to be accepted by the RBI at par with regular notes. When enough Pakistani rupees had been printed by the newly-created State Bank of Pakistan, or the SBP, the mix of India rupees and overprinted notes was to be demonetized and replaced by Pakistani rupees on a 1:1 basis.

Here is what the Pakistani overprints looked like.


Note that they have the text "GOVERNMENT OF PAKISTAN" inscribed on them. Otherwise, overprints were just like regular rupees of the time.

---

Let's pause and bring this to the present. Like the rupee breakup of 1947-49, Modi's recent demonetization involved the cancellation of a large proportion of existing currency followed by an issue of new banknotes to replace them. (The 500 and 1000 rupee notes represented some 85% of India's paper money.) This is where the similarities between the two projects end. The architects of partition were wise enough to realize that they did not have enough time to print sufficient quantities of Pakistani rupees to replace Indian rupees, and so to avoid burdening the public with a shortage of cash they decided to use existing RBI-issued currency as a bridging mechanism.

Modi and his team of monetary architects evidently did not bother to familiarize themselves with RBI history. If they had, not only would they have realized what a huge task it is to replace the majority of a nation's currency, but they would also have learnt some tricks—like overprinting—to make the project easier. (Overstamping, a technique similar to overprinting, was successfully used in the break-up of the Austro Hungarian krona in 1991 as well as the Czechoslovak koruna in 1993.) This refusal to draw on the RBI's institutional memory means that some eight months after demonetization, Indians are still suffering from cash shortages.

---

Let's return back to the partition and explore the forking of the rupee more closely. The SBP, which was established July 1, 1948, formally took over the RBI-issued overprints as their liability that same day. As fresh Pakistan rupees came off the printing presses over the next months, SBP officials would steadily replace these overprints. That same day, the RBI subtracted the entire stock of overprinted notes from its total banknote liability. (The RBI had been issuing these notes since April.)

In taking over a large percent of the RBI's banknote liabilities, the SBP would need an equivalent set of assets to act as backing. These assets were to come from the RBI. More specifically, a fixed portion of the RBI's gold, coin, sterling-denominated securities, and rupee-denominated securities was to be transferred to the SBP, the rest remaining in India to serve a backing for RBI-issued rupee banknote.

To ensure fairness, a formula was settled on ahead of time to determine how the assets were to be apportioned. On a fixed date, the RBI would tally up how many notes were in circulation in Pakistan and how many in India, and divvy up the underlying assets according to the distribution of notes. That's fair way to do things, at least in theory. For the overprints, the RBI would record how many it had issued by July 1, 1948, and for each rupee overprint in existence it would transfer an equivalent quantity of assets to the SPB. When July 1 came, some 9.9% of the RBI's assets were dispatched to Pakistan. Thus one half of the mix of notes circulating in Pakistan, the overprints, had been demonetized.

There still remained the second half of the mix—regular Indian rupees. Dealing with these was more complicated. Unlike overprints, the RBI could have no firm measure for how many regular rupees were still being used in Pakistan, and thus had no way of knowing how many backing assets to transfer to the SBP. Intead, a mechanism for tallying up notes was established such that all Indian rupees circulating in Pakistan had to be brought to SBP offices for conversion into Pakistani rupees before July 1, 1949, one year after the central bank's founding. As Indian rupees flowed into the SBP over the course of the next twelve months, SBP officials remitted them to the RBI. The RBI then transferred an equivalent asset to the SBP for each Indian note it had received up until the expiry of the conversion period on July 1, 1949, after which the RBI ceased to accept remitted Indian rupees.

At this point, the RBI and the SBP were officially divorced. All liabilities and assets had been distributed to each respective party.

---

In a potential breakup of the euro, a formula like the one devised by the RBI will have to be used. The results, however, are likely to be messy. Because as I'll show, the divvying up of the RBI's assets wasn't without controversy.

If you look at the SBP's 2016 financial statements, you'll see an interesting line item called "Assets Held With the Reserve Bank of India":

Source


Go to note 14, and you'll see that:
"These assets were allocated to the Government of Pakistan as its share of the assets of the Reserve Bank of India under the provisions of Pakistan (Monetary System and Reserve Bank) Order, 1947. The transfer of these assets to the Group is subject to final settlement between the Governments of Pakistan and India"

So it seem that Pakistan never received what it believes to be its fair portion of the RBI's assets. For almost 70-years now it has carried these IOUs on its balance sheet (see historical date here). That's a long time to hold an asset that is unlikely to be collected! The reason for this odd balance sheet item can be found on page 568 or the aforementioned 900-page RBI tome. Between the founding of the SBP in July 1948 and the July 1949 cutoff date for note remittances to the RBI, more Indian rupees had filtered over the border into Pakistan than expected. As such, Pakistan was able to stake a larger claim on the RBI's assets than initially estimated.

Indian officials, who were not happy with the amount of assets they were sending over to Pakistan, now claimed that only those notes already in circulation in Pakistan as of July 1948 could legitimately be remitted for underlying assets. Any notes that were imported into Pakistan from India after that date simply would not count to the final tally. Pakistani disagreed. In March 1949 the Indian government informed the bank that "pending negotiations with the Pakistan Government further releases to them should be withheld." This was unfortunate news for the SBP. It had effectively issued Pakistani rupees without a reciprocating asset to back them.* That's where the two parties stand to this day—the SBP grudgingly holds the RBI's IOU on its books as reminder that it never got its perceived fair share of the RBI's assets.
---

This sort of havoc is inevitable when a monetary union breaks up. If existing notes are to be converted into new national notes at a one-to-one basis over a fixed period of time, then everyone has an incentive to export their notes to the region that is expected to have the strongest national currency. I am speculating here, but in September 1949—just three months after the RBI had been successfully divided—India devalued its rupee by 30.5%. Pakistan didn't. So all thoe holding Pakistani rupees were suddenly 30.5% richer than those holding rupees. Maybe the mass banknote exodus into Pakistan during the conversion period was an attempt to avoid this impending devaluation.

This same sort of dynamic would surely characterize a euro break-up. If Europeans are given 6-months to convert their euros into new national currencies like the German mark or the Greek drachma, you can bet that everyone will ship their euros to Germany. Drachmas, like the Indian rupee, are sure to be devalued. And if the final distribution of banknotes is to serve as the marker for divvying up the European Central Bank's assets, then Germany would get most of them. Were it to be prevented from getting its share, then Germany would end up in the same situation as Pakistan, with a shortage of good assets to back up all the fresh marks it has issued.

*If you're interested in specific amounts owed, here's an old World Bank document on the issue.