03-28-12 © sserg_dibrovaIt’s quite conceivable that the grandparents (or even parents) of the future will be made to feel even more archaic as the young of that generation look at them quizzically and state “...are you serious? You used to use bits of paper as money?!”

Money is a cultural abstract.   It is the social, cultural and legal consensus of what a given society- at a given time- considers as being money.   When economies are working well- this tends to be the most efficient form of value-exchange (which for most of recent history has been banknotes) but in less stable-times, communities have used everything from checkerboard pieces to playing cards and even pieces of wood as being their chosen mode of exchange. You may laugh, but in the digital-era we unanimously agree that imperceptible bits of data, held in the ether, are a suitable way for us to store and exchange the oxygen of our modern lives

What is money now?

In the post-digital era, it may seem perhaps a legacy of bygone times that we still use aesthetically pleasing pieces of pulped-tree, metal or plastic as our medium of exchange, but as Kenneth Rogoff states,“Despite advances in transactions technologies, paper currency still constitutes a notable percentage of the money supply in most countries. For example, it constitutes roughly 10% of the US Federal Reserve’s main monetary aggregate, M2.” (Costs and Benefits to Phasing Out Paper Currency, NBER Working Paper 20126, May 2014).

In his paper, Rogoff makes a balanced case for and against the elimination of paper money from circulation.

The case to eliminate paper money!

Modern financial markets are behaviorally and structurally different to anything that was previously conceptualized. It would have seemed impossible previously to assert that central banks would ever need to take interest rates below zero, but we exist at a time where that is possible and many argue necessary. “Paying a negative interest rate on currency, or on electronic reserves at the central bank, may seem barbaric to some…” writes Rogoff, “But it is arguably no more barbaric than inflation, which similarly reduces the real purchasing power of currency.”  With any paper money in circulation, and no deflation wiggle-room, it becomes close to impossible for bank rates to (in reality) breach zero.

Paper money also provides anonymity from the government. Rogoff notes that, “Standard monetary theory (e.g., Kiyotaki and Wright 1989) suggests that an essential property of money is that neither buyer nor seller requires knowledge of its history, giving it a certain form of anonymity. (A slight caveat is that the identity of the buyer might be correlated with the probability of the currency being counterfeit, but until now this is a problem that governments have been able to contain.) There is nothing, however, in standard theories of money that requires transactions to be anonymous from tax- or law-enforcement authorities. And yet there is a significant body of evidence that a large percentage of currency in most countries, generally well over 50%, is used precisely to hide transactions.” This is a huge amount of physical cash; around 7% of US GDP, 10% of Eurozone GDP and almost 18% of Japan’s GDP. In the US alone, this underground economy creates a tax-gap of around $450 billion (the European figure, with a much harsher tax regime, would be considerably larger).

The case to keep paper money

As we sit here today (perhaps in large part due to the underground economy) the demand for paper currency is outstripping the potential for that paper currency to be replaced by electronic central bank reserves. If we were to simply stop accepting paper money, the world’s central banks would have to absorb a large proportion of the difference, perhaps upto $70billion per year in the case of the USA. Theoretically it is possible for a government to issue currency which could be de-facto anonymous (using platforms like Bitcoin) however the potential for said money to facilitate a tax-gap and underground economy would continue (a large price to pay for a non zero-bound interest rate world…).

Rogoff also comments that“…another important argument for maintaining the status quo is that eliminating a core symbol of the monetary regime could disrupt common social conventions for using money, possibly in unexpected ways. For example, it could lead to a precipitous decline in demand for debt and not just for fiat money.” He continues, “…just because a similar equilibrium can obtain with or without a significant transactions role for money, it does not necessarily mean that private agents will focus on the same equilibrium as they would when there exists paper currency. Yes, the government can help coordinate expectations by insisting that taxes are paid in the electronic fiat currency, and that all state contracts be denominated in this currency. But it is important to acknowledge that there is a least an outside risk that if the government is too abrupt is abandoning a century-old social convention, it will destabilize inflation expectations, introduce a risk premium into bond pricing, and generally induce unexpected macroeconomic instabilities.”

From a geopolitical perspective also, we see the threat that by eliminating a domestic currency, the population may just shift to using another- again, this is not beyond the realms of reason, many failed states have adopted the USD as the de-facto currency when that national offering ceased to serve its purpose.

The risks of living without paper…

Alongside the obvious risk of electronic currency to cyber-attack and infrastructure failure, there is also the broad-line concern as to whether a full shift to electronic currency introduces in tracking and traceability which would violate our basic civil liberties.

The Future

Despite huge and on-going technological advances in electronic transactions technologies, it [paper currency] has remained surprisingly durable, even if its major uses seem to be buried in the world underground and illegal economy.... Nevertheless, given the role of paper currency (especially large-denomination notes) in facilitating tax evasion and illegal activity, and given the persistent and perhaps recurring problem of the zero bound on nominal interest rates, it is appropriate to consider the costs and benefits to a more proactive strategy for phasing out the use of paper currency." writes Rogoff.

The normalization of innovation into a society (where said innovation becomes accepted as a norm) can happen gradually, or through shocks.

Mobile communications and the internet illustrate this clearly. In western societies, the normalisation of these technologies was relatively slow – taking a couple of decades. In other countries however, they became the norm from day one; for many developing nations, mobile telephony and the internet were inserted into culture as a shock by development groups as the first form of reliable telecommunications ever to be in-place, and so the allied and emergent concepts built on these (such as electronic money and so forth) are not only more prevalent, but highly normalised.

For a true replacement to emerge for paper currency, the step-change in innovation would have to be more than marginally better for some of the stakeholders (as current alternatives are) it would need to be a pivot that gives states, central banks, governments, businesses and consumers a real reason to make the switch.

For my mind, I feel the solution will be more abstract. It would be hard to see (at least in the short or medium term in the western world) a situation where paper currency is truly abandoned- the socio-cultural momentum that would require is perhaps a generation or two away, and will almost certainly require a role-model country elsewhere in the world to show it works.

What we are seeing however is that technology has enabled transactions to occur in the middle-ground between barter and money. Fundamentally money exists when the community using it agrees that it is an acceptable, secure and sustainable store of value. Crypto-currencies and many other technologies in the space are giving credible platforms on which the notion of money can exist. The pace of technological development also means that these platforms move much more rapidly from the development world into the real world; where they can live or die in the markets.

In the future, we could have three layers of currency in our world. A macro layer enabling central banks to trade with each other (perhaps using some modified form of the SDR), a sovereign layer enabling nations or country alliances (such as the EU) to have a core currency as their systemically important money-supply and a third layer; the civic layer- where the community itself creates currencies to facilitate trade between themselves with freedom from policy interference.

More so than any of this, we have to remember that money is a human invention, and a human technology. As Ayn Rand said, “Money is only a tool. It will take you wherever you wish, but it will not replace you as the driver."

Costs and Benefits to Phasing Out Paper Currency

By: Kenneth S. Rogoff Thomas D Cabot Professor of Public Policy
Economics Department Harvard University


NBER Working Paper No. 20126 (May 2014)

JEL No. E41,E51,E52