Will Cash be Made Illegal? by Filipe R. Costa

Can you imagine a world in which you use the euro to pay for your living expenses but you’re not allowed to hold the physical currency? Can you imagine a world in which you’re bound to the electronic transfer of funds and condemned to never see a cent of your paper wealth?

Well, if not, it’s time to prepare yourself for the next trick in central bankers’ bag – a complete ban on the use of cash, paper money, physical currency, or any other means of anonymously holding the medium of exchange. With interest rates already undershooting the zero lower bound, investors should expect a new wave of legal, social and financial aberrations to come their way in the not-so-distant future.

Many readers may think that I am joking, speculating, or even that I’ve lost my mind – such is the aberrational nature of the idea behind a paper currency ban. But I’m serious about it and I can point you to the latest research conducted by Kenneth Rogoff (http://www.nber.org/papers/w20126.pdf) where he argues on the benefits of phasing out paper currency.

While the idea had its origins in 1916 with Willem Gesell, it was further developed more than a decade ago by Willem Buiter, a former UK MPC (Monetary Policy Committee) member. Now, the controversial Harvard Professor Kenneth Rogoff, who in the recent past found a strong relation between high debt and lack of growth (which has been the base for the budget cutting recommended by the IMF but that after all was based on wrong Excel calculations), is marketing it. He came back with new strong claims for the abolition of paper currency, which would not only allow for a stronger monetary policy, but also help to prevent illegal activities…

Before going through the idea of a paper currency, let’s just rewind a little in recent monetary policy decisions to the point where the ECB decided to cut its main refinancing rate to 0.15% in June. At that point, the deposit facility rate turned negative to -0.10%. Later, in September, the ECB decided to further cut its refinancing rate to 0.05% and the deposit facility rate was set at -0.20% level. The main idea is to charge banks for the excess reserves they park at the central bank in a desperate attempt to encourage lending.
As I wrote in a recent article, central banks usually use a Taylor rule as guidance for their policy setting (albeit informally). When economic growth falls below its natural full employment level and inflation is below the target rate, the Taylor rule usually advises a negative nominal interest rate. The output and inflation gaps are such that to induce a decrease in the real interest rate and spur growth and inflation, the central bank needs to cut its key rate to a negative number. But, in general, central banks always assume that there is a zero lower bound for interest rates, as anything lower than zero would lead to an increase in physical currency holdings, which would decrease the effectiveness of the measure.

The intuition behind it is quite simple. When a central bank lowers its key rate, the effects disseminate through the yield curve and spread to many monetary and non-monetary assets. A cut in the main refinancing rate is expected to lead to a decrease in the EONIA, in sovereign debt yields, in deposit and lending rates, in mortgage rates and many other interest rates and implicit yields. So, when the central bank cuts its key rates to negative numbers, it may be the case that banks start charging clients on their deposits and the government is paid to issue debt. So, at some point, you start being charged for your savings.

Are you really willing to pay interest on your current or savings accounts? Are you willing to buy sovereign debt and pay interest on it?

After all you’re lending money and you should be paid for it and not the opposite.

To completely demystify it, let’s think about a simple example. Suppose there is a one-year riskless (or near riskless) zero-coupon bond issued by the German government with face value of 1,000 euros currently trading at 1,025.64 euros. If we do the maths, such a bond has an implicit yield of -2.5%. This means that a buyer will pay 2.5% interest to lend money to the German government. Why would someone buy it?

In the absence of short selling constraints, I would be happy to sell you this bond today and collect 1,025.64 euros. Then I would hold onto the cash, and in one year’s time, I would repay you the face value of 1,000 euros and keep a riskless profit of 25.64 euros. The arbitrage opportunity would eliminate the negative yield. From this we realise that the biggest problem posed to negative interest rates is the existence of physical currency. As long as you can convert any deposit or sovereign holdings into paper currency (which isn’t subject to any interest), there’s no way one can set a negative interest rate.

But, the above isn’t 100% correct. The reasoning assumes that holding paper currency is costless when in fact it isn’t. You can hold the cash, but just imagine how difficult it would be to buy stuff from eBay or Amazon if you were to pay with physical money! Keeping money safe at your home would also be an issue. Keeping 200 euros in your pocket may be costless but the same isn’t true for 10,000,000 euros! You would need to buy a safe or put the money in a bank vault. Now imagine what happens to a company like Apple. If at the first sign of negative rates the company were to convert its short-term investments into cash, it would end up with $25 billion in paper currency, which at the highest dollar denomination of $100 would still mean having to keep safe 250 million notes…

After taking into account the costs of holding currency, we come to the conclusion that in extreme situations companies and households may in fact be willing to pay a fee to keep their money safe and readily available at banks.

That being true, then a negative rate is possible. But it is limited to the carry cost, which may mean 0.25%, 0.50% or eventually 0.75% and could never be 5%. As soon as a central bank surpasses the carry cost, conversions into paper currency would occur and monetary policy would lose traction. But, as I showed in the Taylor’s rule article, in 2009 the nominal interest rate would have to be cut to -8%, -9% or even -10% if the Federal Reserve were to avoid the unconventional measures. At that point, the zero lower bound would turn into a real constraint and that’s why Rogoff wants to prevent us from holding cash. That way, the central bank could tax us for 5%, 10% or even 50% without any problems.

Buiter (heavily marketed by Rogoff) claims that in developed countries we no longer use physical currency much. There is a wide range of alternatives to pay for our daily transactions. We have checkable bank deposits, giro accounts at post offices, credit and debit cards, digital cash, money market accounts, and much more. Paper currency is only used by the poor, for small transactions, and mostly for illegal activities such as drug trafficking, terrorism and so on. So cash is more or less redundant in terms of a medium of exchange and wouldn’t be missed. Its ban would even prevent illegal transactions, as an added bonus. The euro would then earn a new conditional legal tender status – you can hold it as long as you don’t touch it!
In December the SNB cut its key rate to -0.25%, the ECB already holds a near zero main rate and a negative deposit rate, and others like the central banks of Sweden and Denmark have all experimented with negative rates in the recent past, not being far from them now. With fiscal policy arrested and the range of conventional and unconventional monetary measures already deployed, we’re approaching a new level of policy aberration which could end in financial and social disaster. Encouraging households and businesses to consume and invest may be a sound economic policy but forcing them to do so when they don’t want to is utterly reckless.

Saving for future consumption is the key to sustainable growth, not a crime! When you make it illegal to hold cash, you’re telling future generations that it is wrong to save and that they should spend every cent they earn plus any extra they can get through credit. The real irony is that the very same people that want to teach you that saving is wrong criticise political parties like Syriza that want to renegotiate debt. Isn’t debt a consequence of past excesses and a lack of savings?

P.S. For those who still think the cash ban is a solution to drive growth, I just ask you to think on the following: Do you really think people wouldn’t find their way into other means of exchange like international currencies, gold and other commodities? Do you think drug trafficking would stop? Money as a means of exchange is not what is deemed legal tender but what is generally accepted as that. With money tied to -5% interest rates, imagine how generally accepted would that be…