How Could Digital Currency Work?

The Bank of England and the UK Treasury have announced a Central Bank Digital Currency (CBDC) Taskforce to coordinate the exploration of a potential British CBDC. But how could a digital Pound actually work? As it happens, this is something that Consult Hyperion knows rather a lot about. Apart from our work on the first British central bank digital currency (Mondex) back in the 1990s, our work on the first population-scale mobile money scheme (M-PESA) in the 2000s and our work on the most transformational contactless payment roll-out (Transport for London) in the 2010s, our practical experience across implementation platforms means that we understand the architectural options better than anyone.

Making money for the masses

The discussions around digital currency continue. I had an interesting sort-of-argument with someone about this recently, and I mentioned in passing the dynamics of the shift from specie to token money during the industrial revolution. I think it’s worth expanding on this here, as to my mind it informs the debates about central bank digital currency vs. private digital money, an important debate for our times. There’s lots more about this on the blog and there’s a podcast about it too if you are interested in learning more.

Forum friend George Selgin gave an excellent talk on this at [Consult Hyperion’s 2010 Forum], exploring the transition to industrial-age money.

[From The problem of change | Consult Hyperion]

The essence of George’s talk was that industrialing Britain saw unexpected changes in the way that money worked as it strove to re-invent money for its new economy. As the nature of that economy had changed, so the nature of money had needed to change too, but there is a lag and a tension between the needs of the economy and the money that the economy has inherited from an earlier age. At the time, it was not clear exactly what needed doing. People could see that there were problems, but not what do to about them.

Naturally I refer to this time because the Internet, mobile phones and online commerce are creating a vortex that is sucking in monetary innovation at an accelerating rate. My point is that we have been there before and can learn from those distant times. Consider the relationship between private and public provision of small change (coins, essentially) that has been brought back into focus by discussions about micropayments in an online world before. When that industrial revolution caused an explosion in population and commerce in Georgian England, the lack of small change shifted from being an annoyance to being a major national problem, holding back growth and development. Factories had no coins to pay their workers, workers had no coins buy their essentials and the economy was suffering. Josset’s description from “Money in Britain” (1962) is lovely:

Rarely was any transaction made without an argument. No trader would sell goods without stipulating the weight of the coins in which he was to be paid. Quarrels over money values were continuous; market days and fairs were regularly scenes of brawls. Wages paid by employers to their workers were the cause of many Saturday night disputes regarding the value of their money. Such was the result of the apathy and ignorance of the government in so neglecting the currency.

Essentially, as I wrote before, it was Main Street vs. Wall Street as usual (there you go brining class into it again):

What happened in that case was that there was money for the wealthy (bank notes and gold and silver coins) but there was no money for the masses. You couldn’t by a loaf of bread or pint of beer with the banknote or a silver coin, so private industry stepped in to mint copper token money, and this money circulated particularly in industrial centres in order to (very successfully) facilitate wage payments and retail spending.

[From Up a gum tree | Consult Hyperion]

By the end of the eighteenth century, most of the coins in circulation in the Britain were counterfeits. Gresham’s Law meant that there was widespread acceptance of counterfeits because there were no legal coins in circulation and that the good counterfeits served a useful economic purpose. A shopkeeper might have four copper trays in his till: pennies, ha’pennies, good counterfeits of same and “raps”, or counterfeits that could not easily be passed on.

The government did nothing about it. The people who did do something about were technologists: those at the centre of the industrialisation storm, largely from Birmingham, which was the Georgian Silicon Valley. The nascent metal-bashing industry there, the emergence of organised production (Matthew Boulton’s factory) and the expanding skill base meant that the skills, techniques and supply chain for medals, buttons (and the machines to make them) could be readily adapted to coins. The industrialists used the latest technology of steam presses whereas the government did not. At the same time, the supply of copper (the world’s largest copper mine was in Anglesey in those days) meant that the right raw material was in the right place at the right time.

What was the result of this technological change? It was that coins changed from commodity money (ie, gold and silver to the face value) to token money (ie, base metals and alloys worth a fraction of the face value). And it was, crucially, the private sector that caused the shift, with the public happy to accept the token money that, presumably, no-one in the government would. (As an aside, George Selgin asks in his splendid book why the private mints put so much effort and invention into creating such good quality tokens and suggests that part of it was marketing: good-quality tokens were good publicity and advert for the skills of the companies.)

These tokens gained rapid acceptance and by the end of the 18th century  the problem of small change was almost solved with the official (or “Tower”) coins trading at a discount against the private alternatives. What happened then? Well around two decades later, the official government mint adopted token currency and began issuing modern coins. This is, I think, a marker for our age and one of the reasons why I am so certain that, at some point in the future, the government will adopt a digital money that is in widespread use in the private sector (let us set aside exactly which technology for the time being) as a national digital currency and make the final shift of cash from atoms to bits.

The reason that I am so interested in this particular case study is that I think it has tremendous resonance in the current day. We are living through the post-industrial revolution but we are still using the money of a different age. Just as people in the early 17th century couldn’t have imagined the Bank of England, paper money and the Gold Standard that were just around the corner, so we can’t imagine the money of the near future.

Bank of England Charter sealing 1694

Somewhere out there, private enterprise (a student in a garage or a researcher in a regtech) is working on the money for the post-industrial age but we don’t yet know what it is. I’m pretty sure it’s not Bitcoin, and I’m pretty sure it will have something more to do with the communities that it serves than the fiat currencies of the nation-state do, but I don’t know what it is any more than anyone else does. However, it is interesting to speculate that the trajectory might replay. There will be competition to produce the money that the new economy needs and then when that competition means it’s no longer possible to make a living from the means of exchange because the transactions fees are driven down to zero, it will become some form of public good (even if the definition of public is more limited to “public within multiple overlapping communities”).

In which case, the world’s central banks might at well starting providing digital money as a public good now! Seriously, how much would it cost to set up Bank of England PESA? They might even look at some form of shared ledger solution, where copies of the “national ledger” are maintain by regulated financial institutions (e.g., banks – whereby taking part in the consensus-forming process would be a condition of a banking licence) and the entries in those ledgers related to transfers between pseudonymous accounts (i.e., your bank would know who you are but the central bank, other banks and auditors would not). I think this is just the sort of topic that we should explore at the twentieth annual Consult Hyperion “Tomorrow’s Transactions Forum” in London on the 26th and 27th April 2017, so you should probably block those days out in your diary right now…

The Bavarian Savings Bank Association and large-denomination banknotes

The European Central Bank (ECB) interest rate for bank deposits is currently minus 0.4% and economic theory would predict that at a minus rate, depositors (and this includes companies as well as banks and individuals) would prefer to hold cash rather than pay the central bank to look after their money for them. It has to be said that this doesn’t appear to have happened on a large scale yet, but clearly one of the reasons why economists are interested in getting rid of cash is in order to allow the interest rates to go further into negative territory in order to stimulate economic activity over hoarding. Now, it clearly costs something to manage cash over and above the cost of managing an electronic deposit hence it is interesting to speculate what the crossover rate might be, the modern version of the old “specie point” at which it was cheaper to hold bullion for monetary purposes rather than paper instruments.

In Germany, this calculation is being made. The negative interest rate cost German banks about a quarter of a billion euros last year, which has set them thinking about how negative the interest rates needs to be in order to make it worthwhile to store cash instead of holding deposits at the central bank. The Bavarian Savings Bank Association has already sent around a circular to their members setting out their version of the calculation. On this basis, the crossover rate is actually less than half of the current negative rate: we’ve already crossed the crossover point, if you see what I mean.

With 1.50 euros plus insurance tax for 1000 Euro, the value would be at 0.1785 percent, below the ECB’s deposit penalty rate of 0.3 percent, it said. Additional costs for CIT or additional burglary protection are not taken into account.

From Penalty interest: Unions want money rather stash in the vault – SPIEGEL ONLINE

 This isn’t really a serious calculation because, as it says at the end, it doesn’t take into account the significant costs of cash in transit (CIT) or the additional security expenditure that would be needed to guard cash hoards. But it does make a fun point, at least to me, which is that the existence of the €500 notes has an impact on that crossover rate. Clearly, if the maximum denomination banknote in Europe was (as it should be) €50 then you will need 10 times as many of them to create a hoard of the same value and that means higher costs for storage and transport. Now that the ECB has decided stop printing the 500s, banks will have to store masses of 200s, so the cost of storage and transport will be higher (which, in turn, will put a premium on the 500s in circulation so that they will trade above par). Just as an indication, two billion euros in 200 euro notes weighs about 11 tonnes.

The calculation may not be complete, but it does make an interesting point, which is that although we have passed the crossover point already, no banks have to date decided to store their squillions under the mattress rather than leave them on deposit. Oh, wait…

Commerzbank, one of Germany’s biggest lenders, is examining the possibility of hoarding billions of euro in vaults rather than paying a penalty charge for parking it with the European Central Bank, according to sources familiar with the matter.

From RTÉ Mobile – Commerzbank may hoard cash to avoid ECB charges

Why on Earth would they want to do this? Does it really make any sense? Either they will be setting themselves for the biggest robbery in history when thieves eventually get in to the vault, or they will be incurring costs that are insanely high in order to prevent this. I hope they’ve got good insurance. Or perhaps they can crowdsource the security from loyal customers, as Barclays once did in the UK.

Bank customers had to stand guard after a branch of Barclays was left unlocked for almost four hours. Even the cashiers’ service area and the route to the vault were left open to passers-by in Leigh-on-Sea, Essex, on Saturday afternoon. The blunder was only noticed when a customer went into the branch to withdraw cash and found no staff present.

[From Blundering Barclays bank staff go home… and FORGET to lock up or set the alarms]

It seems to me that the costs of transport, security, insurance and so on are actually quite high, so the ECB will be able to push interest rates further negative before it gets close to a genuine crossover point that would see banks investing in larger mattresses. If the ECB wants to have negative interest rates in its monetary policy toolbox in the long term, however, it would make sense for them to institute discussions about a practical policy on a cashless Europe, a topic that I will be talking about with my good friend Geronimo Emili of CashlessWay at the end of his NoCashTrip3 at Pay360 in Liverpool next Monday. See you all there!

There you go bringing class into it again

Cash continues to dwindle in the UK, albeit slowly. No-one really needs it any more, except to pay people smugglers, although I suppose it might find a niche amongst hipster nostalgics sort of like vinyl records. I don’t need it to buy stuff in shops since I won’t go to a shop that doesn’t take cards. I don’t even need it to provide a stream of subs to student children, since the requests and the responses all go via PingIt now. Apparently I’m not the only one.

Continued growth is also predicted in the Faster Payments Service as more consumers move to online and mobile payments. These payments will more than double over the next 10 years, with 1.9 billion one-off and forward-dated payments forecast to be made in 2025.

From Debit cards to overtake cash in UK by 2021

When you can send money, instantly, from any bank account to any other bank account it’s hard to imagine what you might need cash or cheques for. We have the annoyance of having to give out sort codes and account numbers from time to time, but PingIt and PayM allow us to send money to mobile phone numbers and I imagine that an outcome of Payment UK’s deliberations on payee confirmation may well be the creation of a database of “paynames” (i.e., £dgwbirch) to make casual instant payments even easier.

On a typical day, I leave the house with no cash. I buy my bus ticket on my mobile, I use a card at the train station (they still don’t take contactless in the ticket machines) and I use contactless cards or (more usually) mobile to buy coffee and lunch and so on. I’m quite surprised that some shops still go through the pfaff of messing about with cash, especially when I nip in for some milk and the person in front of me is buying a couple of things and paying with a £20 note that means that I have to wait while they have change counted out for them. I don’t know why they bother. Actually, some of them don’t.

Healthy high street food chain Tossed has today opened what is thought to be the UK’s first completely cashless restaurant. Two new stores in Central London have been fitted with self-service kiosks, instead of manned tills, taking payment by credit or debit card, contactless, or Apple Pay instead of cash.

From Tossed opens the UK’s first entirely cashless restaurant

I’m surprised that supermarkets don’t already have cash-only lanes so that the rest of us can zip through. In fact, I would have thought that in some areas the cashless supermarket cannot be far away. I say in some areas, because I see cashlessness as a class issue. And I can prove it…

Waitrose is set to become the UK’s first major supermarket brand to operate a cashless store, where only card and mobile payments are accepted… Five self-service checkouts in the store will accept credit, debit and contactless card payments, as well as mCommerce tools that use near-field communication technology such as Apple Pay.

From Waitrose follows cashless store trend – Essential Retail

I should explain to our foreign readers that Waitrose is commonly understood to be the most middle-class of all shopping experiences. Yes, well, OK I know it’s only the Waitrose store on the Sky campus, but it’s a start. We are nation of debit card users. The middle classes rarely carry cash and use it only for paying tradespersons off the books.

 Apple Pay !!

The Apple Store still accepts cash.

The less well off remain trapped in a cash economy that loads costs on to them for no benefits. This is certainly an issue and it demands a national strategy for cash replacement, but as we don’t have one we will see continuing bifurcation as the poor are forced to bear the costs of cash while the rest of us dump it. This is not far-fetched techno-blinkered optimism, by the way. Cashlessness has a toehold and is beginning to spread.

Alex Wrethman, owner of the Charlotte’s Group restaurant business, decided to make his most recent opening, W5, an entirely cashless affair. “We are entirely cashless, it’s cards and Apple Pay only. There’s no going to the bank. There’s no cash on site which takes about two and a half hours a day to count. We reduced our insurance as we don’t have cash handling and the opportunity for theft is not there,” he says.

From Welcome to a cashless future where retailers recognise our faces | Guardian Small Business Network | The Guardian

Now I suppose this policy might deter the occasional oligarch or drug dealer but I shouldn’t imagine the general public much care, since anyone who can afford to go to the restaurant will have a  card, phone, bracelet, hat, badge or whatever.

Wrethman is passionate about cashless businesses and believes it is the way forward. He also says most customers “don’t care” as most use their cards or Apple Pay regularly anyway and prefer better prices as a result of cuts in administration.

From Welcome to a cashless future where retailers recognise our faces | Guardian Small Business Network | The Guardian

That last point is really telling. As has often been pointed out, as cash usage slowly dwindles, it doesn’t result in much of a saving for retailers. But when cash stops, the retailers can throw away their cash drawers and reconfigure the point of sale, reallocate staff away from dreary reconciliation and cancel the security guards. Reducing cash doesn’t mean big savings, but removing cash does, and without an actual national policy on this, the benefits will go to the middle classes at the expense of the poor. 

A manifesto for cashlessness in Europe

My good friend Geronimo Emili invited me along to a session at Money2020 in Copenhagen today to deliver a manifesto for cashlessness in Europe. He challenged me to come up with a five minute talk (which is very, very difficult for me) that would contain practical advice for European politicians setting their political and economic stalls before an uninformed public. So this is what I said…

Manifesto pic from Scott

Speaking at this year’s World Economic Forum in Davos, John Cryan (the co-CEO of Deutsche Bank AG), said that cash could become history “within a decade”, going on to note that it is terribly inefficient. Mr. Cryan also focused on the way in which cash supports the underground economy, saying that cash should be dematerialised and that governments should be interested in this process because it would make transitions more traceable and would help to combat crime. I agree. Hence it seems to reasonable to ask, and were I to have been present in Davos I would certainly have asked, why it is that central banks keep pumping the stuff out? On Deutsche Bank’s home turf, for example, cash is already undermining the law-abiding majority. The Bundesbank estimate that only 10-15% of the cash in Germany is used to support the needs of commerce and this tallies with the Bank of England’s estimates of the cash used for what they call “transactional purposes”.

So in two of the world’s largest economies, at most a quarter of the cash out there is actually used as a medium of exchange. And this fraction is, as you might imagine, steadily falling as cash is replaced at POS and, increasingly, in inter-personal transactions.

If we look around the world, we can see that some countries are on the verge of cashlessness, others are a long way from it. In Europe, we should make it a goal! We must aim to be effectively cashless in the timescale he discusses. By cashless, incidentally, I do not mean that every single banknote and every single coin has been ritually cursed and then hurled into Mount Doom. By cashlessness, I mean that cash has ceased to be relevant to monetary policy, become irrelevant to most individuals and vanished from most businesses.

As we look to the future, we can begin to ask, quite reasonably, whether developments in digital payment technology and changes in payments and banking regulation will bring us to the point of this kind of cashlessness within, say, a generation (as Mr. Cryan and I expect)? The answer is probably yes, but that doesn’t mean we can’t take action to make sure! Assuming there still is a European Union in a decade then there will still be Euro banknotes and there will still be Euro coins. But they won’t matter for business or for the economy. Without policy changes, however, this will leave us with a cashlessness that is too conservative to reap the benefits of a truly cashless economy, too disorganised to reign in the criminal exploitation of cash and too wedded to the symbolism of physical money to switch it off (just as we switched off analogue TV not that long ago).

That “rump cash” (and I exclude various categories of post-functional cash from this definition) should be actively managed out of existence.

Europe needs politicians to take this seriously and put forward concrete and reasonable plans to achieve effective cashlessness. This is hardly a new thought! Returning to Davos, two decades ago at the 1997 World Economic Forum there was a discussion about the electronic cash that attempted to cover all of the relevant topics and I think it provides a useful starting point. I’ve updated that list of issues and brought them together in a structure that I think rather helpfully identifies four key policy areas for European governments to focus on.

Electronic Money Issues grey


Identifying practical actions to take in each of these policy areas gives us a “manifesto for cashlessness” that policy makers can add to their agendas across the continent. There are immediate and significant benefits to countries, companies and citizens.

Money supply

Governments are responsible for managing the money supply, but they presumably want to the system to deliver an efficient money supply for the modern age. But right now, European money is really, really inefficient. Jack Dorsey of Twitter and Square fame once tweeted that “In general, the shift toward a cashless society appears to improve economic welfare.” He is, of course, correct and we must “nudge” consumers toward this future.

The European Central Bank has published a detailed analysis of the costs of retail payments instruments (Occasional Paper no. 137, September 2012) with the participation of 13 national central banks in the European System of Central Banks (ESCB). It showed that the costs to society of providing retail payments are substantial, amounting to almost 1% of GDP for the sample of participating EU countries. Half of the social costs are incurred by banks and infrastructures, while the other half of all costs are incurred by retailers.

My friend Professor Leo van Hove, Europe’s foremost expert on such matters has long held that cross-subsidising cash is not a welfare-maximising strategy. The social costs of cash payments represent nearly half of the total social costs and as the proportion of retail payments made in cash falls, so in some countries cash already does not have the lower cost per transaction. These social costs of payments systems have only recently been studied to any degree of accuracy by, for example, the Dutch and Belgian central banks (who found the social cost to be .65% and .74% of GDP respectively). In both of these countries, which have well-developed debit infrastructures, cash accounts for three quarters of the total social cost. (In other words, each family in the Netherlands pays about 300 Euros per annum to use cash.)

Dr Laura Rinaldi from the Centre for Economic Studies at Leuven University, carried out some research which confirmed that customers see cash as being “almost free” despite the costs. She concluded that proper cost-based pricing would shift debit cards from being 4% of retail transactions in Europe to a quarter, a change that would add 19 basis points to the European economy.

Manifesto Commitment 1: we will halve the total social cost of the payment system in the next decade, starting by allowing retailers to surcharge for all forms of payment including cash, except for “card present / cardholder present” debit.

Criminal activity

The high-value notes account for more than half the outstanding currency in many OECD nations, are mainly held for stashing, hoarding and exporting. The non-utility of these notes was highlighted in a 2011 ECB survey among households and companies that estimated that only around one-third of the €500 notes in circulation were used for transaction purposes and that the remainder were hoarded as store-of-value in the euro area or held abroad. Recent figures from the Bank of England show a similar pattern, with about a quarter of the cash in circulation used for transactions. High-value notes no longer support trade and industry. Dr. Rinaldi’s research mentioned above further concluded that shifting European economy away from cash would grow it an additional nine basis points because moving to electronic money would shrink the cash-based “shadow economy”.

The European Commission has already said that it wants to investigate the connection between cash (specifically €500 notes) and terrorism. Cash, however, is desirable for all sorts of criminal purposes, not merely terrorism. Now, clearly, removing cash won’t end crime. The reason to make electronic money a firm policy goal is to raise the cost of criminal activity. Whether that crime is drug dealing or money laundering, bribing politicians or evading tax, cash makes it easy and cost-effective.

Manifesto Commitment 2: We will remove €100, €200 and €500 notes from circulation within five years and €50 (and £50) notes from circulation in a decade.

Social policy

UK research indicates that families who use cash are around hundreds of pounds per annum worse off than families who don’t. The reasons are multiple: the cost of cash acquisition, the inability to pay utilities through direct debit, exclusion from online deals and a variety of losses. There’s something unfair about this. People who choose to exist in a cash economy to avoid taxes (e.g., gangsters) are cross-subsidised by the rest of us. People who have no choice but to exist in a cash economy are not cross-subsidised at all.

Those Europeans trapped in the cash economy are the ones who are most vulnerable to theft and extortion, most likely to lose their hard-earned notes and coins or have them destroyed by monetary policies, paying the highest transaction costs, lacking credit ratings or references and (in an example I once heard from Elizabeth Berthe of Grameen at the Consult Hyperion Forum back in 2011) most likely to have their life savings eaten by rats. So what should be done?

Well, the answer is clear. Make electronic payment accounts, capable of supporting account-to-account push payments available to every European citizen at no cost. Notice that I do not say “bank accounts”. Bank accounts are an expensive route to inclusion. Now, financial exclusion is often associated with an inability to provide a proof of identity or address (e.g. immigrants, homeless people), unemployment or financial distress in general and low educational attainment. Electronic money itself does not attack any of these issues hence we must have relaxed KYC for low-maximum balance accounts.

Manifesto Commitment 3: We will regulate for an on-demand electronic payment account capable of holding a maximum of €1,000 without further KYC other than unique recognition (e.g., a mobile phone number).

Control and regulation

With electronic payment accounts available to all and no necessity for cash in day-to-day transactions, we must be sensitive to privacy of transactions. Regulatory authorities ought to be able to monitor economic activity and the advantages of knowing in near real time what is happening in the real economy ought to be substantial for national economic management. However, there is a world of difference between the Minister of Finance knowing that people spent €1,548,399 in restaurants yesterday and knowing that I spent $8.47 on a burrito in Chipotle.

Most of the concerns that reasonable people have about moving away from cash are to do with privacy and security. Since we will have to have security in order to have privacy, we should set our goals around privacy as the central narrative to address these concerns. We have all of the technology that we need to deliver payment systems with the appropriate degree of pseudonymity for a democratic and accountable society.

Manifesto Commitment 4: We will create a privacy-enhancing infrastructure for transactions and for the sharing of transaction data, beginning with a law preventing payment cards from displaying the cardholder name either physically or electronically.

I hope that you will all agree that these deliver a sensible and practical set of steps to improve the lives of European citizens and I look forward to your comments!

Where is the aggregate demand for cash coming from?

A few days ago, I happened to be at an event where the Chief Cashier of the Bank of England gave an interesting speech about the trajectory of banknotes. These are important to the Bank of England, because the note issuing department of the bank is the most profitable nationalised industry in history. And demand for their product continues to grow.

Aggregate demand for Bank of England notes has grown quickly, increasing by around three-quarters over the past decade, and has outpaced the growth in GDP since the 1990s. Today there are nearly three-and-a-half billion notes in circulation, totalling over £60bn.

[From Working together to deliver banknotes for the modern economy – speech by Victoria Cleland | Bank of England]

But what was most interesting to me about the speech, since I don’t care about plastic banknotes and Victoria seemed most unenthusiastic about my campaign to have Sir Thomas Gresham replace the Queen on all British banknotes when I told her about it afterwards, was that she gave up heads up on today’s Bank of England Quarterly Review (3Q15), in which the Bank looks at cash usage. In the same speech, Victoria said that while “demand for cash as a medium of exchange appears broadly stable, its use as a store of value appears to have grown… We estimate that around 20% to 30% of total UK cash was in, what we refer to as, the ‘transactional cycle’ – cash held by banks, consumers, and retailers for the purposes of facilitating everyday transactions”.

In essence she said that their latest figures show that only about a quarter of the cash that they put into circulation is for transactional purposes (i.e., used). The rest of it is either shipped overseas (i.e., exported), which we will put to one side for the moment, kept outside of the banking system (i.e., hoarded) or used to support the shadow economy (i.e., stashed). In other words, not in circulation at all but stuffed under mattresses.

UK banknotes GDP:ATM

If you look at the trend growth of that cash “in circulation” over the last few years it has accelerated well ahead of trend GDP growth as well as past trend ATM withdrawal growth. And we also know that the use of cash in retailing has continued to fall steadily so the “cash gap” between the small amount of cash that is used to support the needs of commerce and the large amounts of cash that are used for other purposes has been growing. The interesting question that the Quarterly Bulletin article by Tom Fish and Roy Whymark stimulates is straightforward: “if the majority of Bank of England notes are not being used for everyday transactions in the domestic economy, what are they being used for?”

I was invited to write a comment piece on this for The Guardian, so having looked at the high level picture I thought it would be interesting to look at each category and what the key drivers in each of them might be. The first, cash that is used, is easy. We know that the driver is technology but that the impact is weak. In other words, new technology does reduce the amount of cash in circulation, but very slowly.

Moving on to the next category, I know it’s a rather simplistic analysis, but if the amount of cash that is being hoarded has been growing then that would tend to indicate that people have lost confidence in formal financial services or are happy to have loss, theft and inflation eat away their store of value while forgoing the safety and security of bank deposits irrespective of the value of the interest paid. The Bank say that “a small number of individuals hoard large amounts of cash” (Ken Dodd, rather famously, had £336,000 in suitcases in his attic) and so might account of a lot of the notes.

If, on the other hand the amount of cash that is being stashed has been growing then the Bank of England is facilitating an increasing tax gap that the rest of us are having to pay for. In this context cash is a mechanism for greatly reducing the cost of criminality while it remains a penalty on the poor who have to shoulder an unfair proportion of the cost of cash. In this case, we should expect to see a strategy to change this obviously suboptimal element of policy.

The amount of cash that is being exported is hard to calculate, although the Bank itself does comment that the £50 note (which makes up a fifth of the cash out there by value) is “primarily demanded by foreign exchange wholesalers abroad”. I suppose some of this may be transactional use for tourists and business people coming to the UK, and I suppose some of it may be hoarded, but surely the strong suspicion must be that these notes are going into stashes.

The Bank notes that “given the untraceable nature of cash” they cannot tell where cash is going. That’s true. I’m not suggesting we adopt the Chinese policy of having ATMs record the serial numbers of notes that they dispense and having cash recycling centres record the serial numbers of notes coming in to rectify this lack of data, but clearly we can look at some proxies to help us establish the rough proportions of used and hoarded, stashed and exported. The Bank says that it thinks around 25% is used and around 25% is hoarded, the rest stashed and exported. If most of the exported cash is stashed, then heading towards half of the cash out there is for, not to put to fine a point on it. criminals. 

So where is the demand coming from? The Bank says that “no single source of demand is likely to have been behind the sustained growth” but I’m not so sure, because I think stashes have grown at the expense of hoards. In a fascinating paper that I looked at last year by Prof. Charles Goodhart (London School of Economics) and Jonathan Ashworth (UK economist at Morgan Stanley), they note that the ratio of currency to GDP in the UK has been rising and argue that the rapid growth in the shadow economy has been a key cause. If you look at the detailed figures, you can see that there was a jump in cash held outside of banks around about the time of the Northern Rock affair, but as public confidence in the banks was restored fairly quickly and the impact of low interest rates on hoarding behaviour seems pretty marginal, there must be some other explanation as to why the amount of cash out there kept rising. Two rather obvious factors that do seem to support the shape of the curve are the increase in VAT to 20% and the continuing rise in self-employment (this came up a couple of times in comments to The Guardian piece), both of which serve to reinforce the contribution of cash to the shadow economy. The Bank say that there is “limited research to confirm the extent of cash held for use in the shadow economy”, but Charles and Jonathan make a reasonable estimate that the shadow economy in the UK could have expanded by around 3% of UK GDP since the beginning of the current financial crisis.

While the BoE paper notes that academic evidence does not suggest the black economy is expanding in the UK

[From UK savers hoard at least £3bn of cash at home –]

According to Tax Justice UK, there were £100 billion in sales not declared to UK tax authorities that meant a tax loss of £40 billion in 2011/12 and that will rise to £47 billion this year. That sounds like expansion to me. The IMF have noted that while Her Majesty’s Revenue and Customs (HMRC) is not good at estimating losses outside the declared tax system, which is why their latest estimates for the tax gap are low at £33 billion for 2011/12. And while we all read about Starbucks and Google and other large corporates engaging in (entirely legal) tax avoidance, half of all tax evasion is down to SMEs and a further quarter down to individuals (according to HMRC).  There are a awful lot of people not paying tax and simple calculations will show that the tax gap that can be attributed to cash is vastly greater than the seigniorage earned by the Bank on the note issue. Cash makes the government (i.e. us) considerably worse off.

In summary, I think think that the Bank’s view on hoarding is generous and that it is the shadow economy fuelling the growth in cash “in circulation”. There’s something wrong about this, especially when we know that the cost of cash falls unfairly on the poor. It is time for Bank of England to develop an active strategy to start reducing the amount of cash in circulation. For a start they could take a look at what’s been going on in Sweden where a broad alliance between the government, banks, trade unions (it is their members who get beaten up and stabbed in cash robberies) and Bjorn from ABBA has made it the first country in the world where the amount of cash “in circulation” is falling.

Next week we’ll take a look at the second part of the Quarterly Bulletin article about what might influence the demand for cash in the future.

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