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Has paper money outlived its purpose?

Author(s): Steve Cecchetti and Kim Schoenholtz

 "The anonymity of paper currency can liberate people, freeing them from their governments. "

From Money, Banking and Financial Markets:

Serious people have been suggesting that we think hard about eliminating paper currency. Paper money facilitates criminality and creates the zero lower bound (ZLB) for nominal interest rates. So, why not just get rid of it and replace it with electronic money?

There is an enormous amount of currency out there. For dollars and euros, the value in circulation is in the range of $4000 per inhabitant. In the Japan, the number is nearly twice this big. And, most of the notes in circulation are large denomination: 77% of U.S. currency is in $100 bills, 53% of euro area currency is in bills of €100 or more, and ¥10,000 notes account for 87% of Japanese paper currency.

The arguments in favor of getting rid of all this stuff are powerful. Law-abiding taxpayers simply do not keep this amount of cash around. The natural conclusion is that the extraordinary volume of currency – especially the large-denomination component – is funding illegal activity, both outright criminality and more mundane tax evasion. Eliminating paper currency – forcing all transactions through some traceable settlement system – would surely help reduce this.

Much of the recent discussion about paper money has focused on the second problem it creates: the ZLB. As we noted in a post on ECB policy, the ability to store physical bank notes means that the central bank’s policy interest rate can’t really go much below –0.25%. (In June, the Governing Council lowered the rate on deposits to –0.10%.)  In the absence of paper money, central banks can reduce the nominal interest rate as far as they want by varying the fee they charge banks on their reserve deposits; and banks would presumably turn around and charge their customers for holding deposit balances. Very negative interest rates could help battle deep economic slumps like the Great Recession that began in 2007. (For a nice summary of the arguments, see Miles Kimball’s posts here.)

Yet a third big bonus from eliminating currency would be to bring the shadow economy into the light. That is, activities that are evading the eye of tax collectors and national statisticians would be forced out into the open. For some countries, even advanced ones, the potential gains are quite large.  Recent estimates suggest that Spain, Portugal, Italy and Greece, the most prominent examples, have shadow activity that is roughly one-quarter the size of officially measured activity (see the chart below).

Source:  F Schneider, A Buehn and C E Montenegro, “Shadow Economies All over the World New Estimates for 162 Countries from 1999 to 2007,” World Bank Research Working Paper No. 5356, July 2010.

Source:  F Schneider, A Buehn and C E Montenegro, “Shadow Economies All over the World New Estimates for 162 Countries from 1999 to 2007,” World Bank Research Working Paper No. 5356, July 2010.

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