In defense of cash

Author: William Luther - Assistant Professor of Economics at Kenyon College, Director of the American Institute for Economics Research's Sound Money Project, and Temporary Fellow at the Center for Monetary and Financial Alternatives at the Cato Institute.

Shortly before November 2016, Indian Prime Minister Narendra Modi said in a speech that 500-rupee notes (worth about $8) and 1,000-rupee notes would become “worthless pieces of paper” at midnight that night and would no longer be recognized as legal tender. The stated goal of his demonetization plan: fighting crime. The government offered a short window in which old notes could be exchanged for new ones, with the idea that everyone from human traffickers to tax evaders would rather show up at banks with huge amounts of cash and confess their sins than let all that money go to waste.

The cost of this scheme was enormous. At the time of this announcement, the 500 and 1,000 rupee notes accounted for 86% of all money in circulation. As economist Lawrence White of George Mason wrote: “A serious shortage of money immediately set in, and it had the expected results. In an economy based largely on cash, honest wage earners could not be paid for their labor, quality construction projects were frozen, ordinary retailers suffered a drastic drop in sales, and honest businesses went bankrupt. Honest people wasted billions of hours waiting in lines outside banks to exchange old notes for new ones.”

India's GDP growth fell from 7.37% year-on-year in the quarter before the announcement to an average of 6.06% in the first 3 quarters of 2017.

More importantly, the plan failed miserably in its goal of punishing shady businesses. Violators were not left with a pile of worthless notes. Instead, the Reserve Bank of India reported that 98.96% of all notes withdrawn from circulation had been returned to banks in the months following the announcement. This is almost on par with the returns of old money in Italy (99.15%) and France (98.77%) after the introduction of the euro, in which cases citizens were given 10 years to exchange their old notes.

The Indian experiment was a failure. Yet many politicians, academics, and well-meaning people continue to dream of a cashless world, where black markets and shady businesses would disappear and tax collections would increase.

Is cash for criminals?

In his book The Curse of Cash (Princeton University Press), Harvard economist Kenneth Rogoff provides the best argument for demonetization in America. He estimates that more than a third of all dollars in circulation in the domestic economy are used by criminals and tax evaders, and that this percentage is even higher for larger denominations. Rogoff concedes that “crime will continue to exist with or without cash, but for very good reasons cash is a payment method highly favored by shady businesses, and that shady businesses account for much of the demand for cash.”

Rogoff proposes the immediate elimination of $100 and $50 bills. He argues that very few people use large denominations in legitimate business. There is no problem for them as long as they can switch to smaller denominations with little effort, and he argues that they could, because such a reform would create minimal problems.

But Rogoff doesn’t stop there: In his scheme, most small-denomination banknotes would also have to go. This would happen over a longer period of time—a decade or more. To promote the transition, the government would have to subsidize deposit accounts. Perhaps through rebates for people who have deposits or through direct payments to financial institutions. Or by requiring all salaries to be transferred by direct deposit. The smallest denomination banknotes could remain in circulation, or better yet, be replaced by coins—they are heavier and therefore less convenient for large transactions. That way, some minimal level of financial privacy would be preserved.

This proposal promises to bring significant benefits in terms of reducing crime and tax evasion, while creating few costs for those who use cash in legitimate businesses. Who wouldn’t want that? In fact, the idea has led to the creation of a strong coalition between Better Than Cash, along with the United Nations Capital Development Fund, the United States Agency for International Development, the Bill & Melinda Gates Foundation, the Omidyar Network, Citi, Visa, and MasterCard, all of whom donate more than $1.5 million a year to the cause.

The philosophical argument in favor of caching

The argument for cash suggests that we should be free to make whatever choices we want in our lives, as long as they don't hurt others. It states that governments have no right to have information about the intimate details of our lives.

Whether they realize it or not, Rogoff and other demonetization advocates have a progressive mindset about government. They think that existing laws and regulations are rationally created by enlightened experts or are the product of an enlightened electorate. If the right people are elected, the social system can be calibrated in detail.

Demonetization advocates are certainly not utopians. They understand that the world is complex, that sometimes bad rules are adopted, and that rules that were good in the past can persist long after their usefulness has expired. But to them, it simply means that a little more calibration is needed. In their view, removing cash removes one of the flaws in an otherwise pretty good system.

There is, of course, an alternative view of government—that of the skeptic, who believes that laws and regulations are not (so) rationally designed. This logic argues that they are more likely to be a contradictory mess, passed down from generation to generation and modified over time. Some of these rules promote fair behavior among people. But others simply reflect the interests of existing power structures: They are designed to benefit some at the expense of others, or to promote values that are not shared by all.

Classical liberals believe that individuals have the right to pursue their own interests as long as they do not infringe on the rights of others. In general, therefore, they believe that the power of the state should be limited. Certainly, governments can be used for good. But both theory and experience show that they do not always make the right choices. What is more important is to minimize the harm that such a powerful institution can create.

It is easy to see how these two perspectives could lead to radically opposite conclusions about the need for cash. Physical currency allows one to disobey the government. If government is a means to an end, circumventing its orders is generally bad for society. On the other hand, if the government must first prove the legitimacy of its desire to interfere in people's lives before it can do so, a blanket ban on cash is too general. Every individual should be free to act freely to a greater or lesser extent. And governments should only intervene in those areas where there is substantial reason to believe that someone has been harmed by someone else. You could call it a moral concession in favor of freedom.

The important thing is that this argument in favor of cash is not at all a defense of criminals and tax evaders, as someone on the other side would try to convince you. It is an argument in defense of fair trial and financial privacy - the foundation of the legal principles of the Western world.

You might think that even if the advocates of cash are not motivated by a desire to promote crime and tax evasion, these could be consequences of their policies. And indeed, such side effects are inevitable. But we should always keep two things in mind.

First, some crimes are defensible. Detaining an illegal immigrant may be illegal, but it is not morally wrong. The philosophy of liberalism is clear: It is beyond the legitimate scope of government power to restrict the freedom of individuals to pursue their own ends when their actions do not harm others. To the extent that cash allows individuals to evade unjust laws, it is a bastion of liberalism.

Second, the rule of law requires that we accept some limits, even in the prevention and detection of crime. A cash ban may make it harder to hire a hitman or sell some stolen goods on the black market. But it does so while also preventing many law-abiding individuals from making perfectly legitimate transactions.

The cost of a cashless society

It is not necessary to rely on a phantasmagoric philosophy to oppose demonetization proposals. There is also a fairly pragmatic argument that can be made. In short, the negatives of a cash ban probably outweigh the possible positives.

Let's start with the positives. Since cash allows for quasi-anonymous buying and selling, it seems logical to assume that it is used by criminals and tax evaders. Banning cash, as many demonetization advocates suggest, would certainly eliminate some of the crime and tax evasion. The question is: To what extent will it improve the lives of the average citizen?

There is no doubt that some types of crime make our lives worse. Most of us certainly want to combat murder, human trafficking, and theft, for example. If eliminating cash reduced the incidence of these crimes, we would add that fact to the group of arguments against cash.

But the positive effects of eliminating other types of crime are less obvious. Take prostitution, for example. Where exactly is the externality that harms others in society here? What price are those who engage in consensual sex imposing on others? Anyone might find these transactions repugnant. However, it is hard to see how society as a whole would improve dramatically by prohibiting people from selling certain goods and services, especially when they affect only the private lives of those involved in the transaction in question.

It seems logical to assume that the crackdown on much of the criminal activity affected by the ban on cash is of dubious benefit to society as a whole. Between February 2011 and October 2013, the online marketplace Silk Road facilitated transactions involving illicit goods and services. Transactions on this platform were made via Bitcoin, which, like cash, allows for potentially anonymous transactions. Despite a few bombastic headlines about hitmen being hired through the site to protect its secrets (there is no evidence of any murders ever being committed on this occasion), all available evidence suggests that the listings on Silk Road almost always involve controlled (or banned) substances such as drugs. A 2013 report by researcher Nicholas Kristin of the Carnegie Mellon Institute was published on the subject. It says that more than 20% of the ads on the site were for marijuana and hashish – goods that are legal for recreational use in eight US states and decriminalized in 13 others.

As for tax evasion, it's definitely bad for government revenue. But that tells us little about the effect on society. When we're talking about overall social welfare, we have to be careful about simple transfers of wealth. The IRS estimates that the difference between what taxpayers owe and what they actually pay is $458 billion a year. The result is that the government is $458 billion poorer per year, but tax evaders are richer by the same amount.

It could be argued that society is harmed as a result—for example, if we assume that the government could have spent this money better than the tax evaders. But even if that were the case, it is important to note two things: First, $458 billion is less than 2.5% of U.S. GDP. And second, it is extremely unlikely that society is worse off if this amount is not going into the government treasury. At least some economic value is added as a result of the additional purchases made with this money by the tax evaders, even if we otherwise find their behavior reprehensible.

Economists who, like Rogoff, support demonetization, point to the "distorting" effects of tax evasion. If some people avoid paying taxes, then a disproportionate burden falls on those who do. Tax evaders can offer their goods and services at lower prices than their law-abiding competitors. This leads to a misallocation of resources, with some high-value businesses losing out to low-value businesses that are more competitive simply because they don't pay taxes.

There is no disagreement on this point – market distortions can cost us dearly. However, the losses from poor resource allocation are certainly equal to 100% of the tax gap (which is small anyway).

Last but not least, Rogoff overstates the extent to which cash is used by criminals and tax evaders. Essentially, he argues that any cash that is not declared on tax returns could be used for nefarious purposes. But at least some of the non-declaration is certainly due to a desire to protect financial privacy or to protect ownership of the cash itself – think of the proverbial grandmother who hides her savings under the mattress – not because she will use such savings to buy illegal goods and services or to avoid paying taxes.

Nothing mentioned so far denies that there would be benefits to society from banning cash. My argument is simply that those benefits are too small for the price we would pay.

Many decent citizens also use cash. Demonetization will make their lives as difficult as it will be for the bad guys. Some transactions will disappear. Financial privacy will be undermined. Mental accounting methods – such as Dave Ramsey’s, in which people divide their money into envelopes labeled “rent,” “fuel,” “food,” “vacation,” and so on – will be eliminated, thereby limiting spending in each category. Moreover, as poorer Americans increasingly go unbanked and rely more on cash than wealthier ones, the negatives of a cash ban will fall primarily on the shoulders of the poorest.

Some proponents of demonetization suggest that law-abiding citizens would be better off in the long run if we forced everyone to work with banks and start using some “better” electronic payment system. This is unlikely. In 2017, a report was released titled “The Curse of Cash” by Lawrence White of George Mason University. He notes that: “conventional economic logic tells us that improving people’s lives means adding more attractive options, not removing what people currently perceive as the best.”

Moreover, there is at least one benefit to tax avoidance: it can serve to set a limit on the extent to which a government can extort money from its citizens. Since taxes eliminate some productive transactions, this could improve social welfare. And since the state needs money to operate, the ability of citizens to rebel against rising taxes (as well as the increasingly authoritarian attitude of their state) allows them to counter government power nonviolently.

Cautionary tale: Venezuela

There is another argument for refraining from banning cash: If an anti-cash policy is introduced in the United States or is supported by respected intellectuals and powerful international organizations, it will most likely lead to its introduction in places where it is not appropriate at all.

Rogoff was very blunt in saying that his proposal “is not aimed at developing countries, where a very large proportion of people lack effective access to banking.” Unfortunately, sophistication and nuance are all too often absent in the political sphere. Politicians use ideas the way drunks use traffic lights: as a fulcrum, not a guide.

Demonetization ideas will naturally appeal to the cash-strapped governments of low-income nations, where such efforts can be used as a one-time tax on banknote holders. By eliminating the value of old notes and putting new ones into circulation, kleptocrats are able to confiscate wealth from those who hold cash without suffering the usual inflationary consequences.

We have already seen a similar policy implemented in India, and this country is not alone. The Venezuelan president used the same rhetoric when he announced in December 2016 that the 100-bolivar note (at the time valued at 2 US cents) would be removed from circulation. He said the almost-worthless note was being collected by the mafia. Initially, the time frame in which old notes could be exchanged was limited to 72 hours, but this period was later extended to January.

In stark contrast to Rogoff’s plan, neither India nor Venezuela has been able to permanently remove large banknotes from circulation. In fact, both countries have added larger denominations to their cash flow—2,000 rupees in India and 100,000 bolivars in Venezuela. It’s hard to believe that the main motive for these moves was to fight crime, given that the demonetized notes in both countries were of relatively small denominations and were later replaced by larger denominations.

Venezuela’s move was part of an effort to tackle hyperinflation (Johns Hopkins University economist Steve Hanke estimates that the country’s annual inflation rate as of February 2018 was about 5,454%. As economist Noah Smith put it in Bloomberg in December 2017, “The country has one of the world’s largest oil reserves and should be fabulously rich. Instead, children are starving.”) Carrying suitcases full of cash to pay for essentials is inefficient, but one way to make the problem less severe is to exchange a large quantity of small-denomination bills for a smaller quantity of larger-denomination bills. Maduro figured that demonetizing the old bills would make the change cheaper for the government because it would push people into the new, larger denominations without compensating them for the smaller ones they wouldn’t be able to exchange before the “window” closed.

Indian policymakers, for their part, probably hoped to generate large, effectively tax-like, revenues from note holders as a result of some people failing to exchange their money before the “window” closed. Although this did not happen in practice (as most notes were eventually exchanged), cash holders nevertheless had to pay the price of the government’s attempt to impose such a tax.

In both countries, few, if any, of the arguments in favor of eliminating cash hold water. Yet both countries have found it politically expedient to invoke the anti-crime rhetoric used to defend the more appropriate ideas of demonetization, while simultaneously imposing a huge financial burden on their citizens.

Cash is still king

The arguments against cash are often presented as a sensible solution to an obvious problem. But the solution is not sensible, and the problem is not obvious. Demonetization proponents show little respect for financial privacy and see no harm in restricting personal freedom. Even the best-laid proposals for demonetization are unlikely to improve matters. At the same time, proponents of these ideas provide intellectual ammunition for others who propose far worse schemes.

The misuse of demonetization arguments in places like India and Venezuela should at least give us pause. It's perfectly reasonable to envision a future where cash is not king. But pursuing that goal by restricting people's ability to use it in the present is a terrible idea.

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