David R. Henderson  

Williamson on Rogoff's Case Against Cash

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St. Louis Federal Reserve Bank Vice-President and economist Stephen D. Williamson has written a critical review of Kenneth Rogoff's The Curse of Cash. I use the word "critical" in the sense we academics use it: a balanced critique that looks at pluses and minuses.

I haven't read Rogoff's book yet, although I did edit an Econlib article, "In Defense of Cash," by Pierre Lemieux, who did read Rogoff's book thoroughly.

While Williamson's piece is balanced, I want to focus on one area in which he too easily accepts Rogoff's thinking about crime and another area in which, if I understand him correctly, Williamson seems to make a basic error in economic reasoning.

Crime

Williamson writes:

Why is cash a "curse?" As Rogoff explains, one of currency's advantages for the user is privacy. But people who want privacy include those who distribute illegal drugs, evade taxation, bribe government officials, and promote terrorism, among other nefarious activities. Currency - and particularly currency in large denominations - is thus an aid to criminals. Indeed, as Rogoff points out, the quantity of U.S. currency in existence is currently about $4,200 per U.S. resident. But Greene et al. (2016) find in surveys that the typical law-abiding consumer holds $207 in cash, on average. This, and the fact that about 80% of the value of U.S. currency outstanding is in $100 notes, suggest that the majority of cash in the U.S. is not used for anything we would characterize as legitimate. Rogoff makes a convincing case that eliminating large-denomination currency would significantly reduce crime, and increase tax revenues. One of the nice features of Rogoff's book is his marshalling of the available evidence to provide ballpark estimates of the effects of the policies he is recommending. The gains from reforming currency issue for the United States appear to be significant - certainly not small potatoes.

Let's look at those four activities cited. Using large denomination bills to promote, or, even worse, carry out, terrorism is clearcut bad. So score one for Rogoff and Williamson.

How about the other three? What you think of them will depend on how you think about these issues. Consider them in turn.

Distributing Illegal Drugs

One of the major costs of the drug war, which gets far too little attention, is that it raises the cost of illegal drugs to those who want them. We, including me, often write about the costs to innocent parties whose property is stolen by drug users. But we typically leave out the costs to drug users, including those who don't steal. The drug war has destroyed a huge amount of consumer surplus for drug users. In any legitimate cost/benefit analysis, those losses should count too. I supervised a thesis on this in 2002: Marvin H. McGuire and Steven M. Carroll, "The economics of the drug war : effective federal policy or missed opportunity?"

How does this matter for the issue at hand? High-face-value currency, as both Rogoff and Williamson recognize, facilitates illegal drug transactions. Getting rid of that currency makes those transactions more difficult, making the cost to consumers higher. That's their point. So in their view, the consumer surplus loss doesn't count. It should.

Bribing Government Officials

Making it more difficult to bribe government officials could be good or could be bad. It's probably bad, as Francois Melese argues in "Corruption," in The Concise Encyclopedia of Economics. In this paragraph, Melese points out both sides of the issue:

Some economists argue that paying bribes to the right officials can mitigate the harmful effects of excessive government regulation. If firms had a choice to wade through red tape or pay to circumvent it, paying bribes might actually improve efficiency and spur investment. Although this view is plausible, a pioneering study by Mauro found that corruption "is strongly negatively associated with the investment rate, regardless of the amount of red tape" (Mauro 1995, p. 695). In fact, allowing firms to pay bribes to circumvent regulations encourages public officials to create new opportunities for bribery.

My point here is that one should not just assume that bribing government officials is bad.

Evading Taxation

Lemieux says it best:

Furthermore, some activities that the law currently defines as crimes (in certain countries) may actually provide useful built-in constraints against abuse of power. Tax dodging, for example, limits the voracity of Leviathan and its tax exploitation. It increases the cost to the state of raising taxes and, thus, tends to maintain them at a level more likely to gain the consent of most citizens.

Moreover, there's one other area where cash does facilitate crime, but that's good, not bad. Lemieux writes:

The same argument applies to the underground economy more generally. It provides a built-in constraint against overregulation. As regulation increases, more people--consumers, entrepreneurs, unfashionable minorities--move to the underground economy. Thus, government cannot regulate past a certain point, and this constraint kicks in more rapidly in a free society.

That cash plays a role in making these built-in constraints more effective against abuses of power is a benefit, not a cost. In a free society, one could provide a cogent argument for increasing the face value of the largest-denomination notes. The largest Swiss note, for example, is 1,000 Swiss francs (roughly the same as $1,000 at the September 22, 2016 exchange rate).

Because of all these constraints, the cost of fighting crime is certainly higher in a free society. But for the vast majority of individuals, the benefits of freedom are even higher. Liberty is not a bug--it's a feature.

Economics of Interest Rates

Williamson writes:

A typical central banking misconception is that a reduction in the nominal interest rate will increase inflation. But every macroeconomist knows about the Fisher effect, whereby a reduction in the nominal interest rate reduces inflation - in the long run.

Here Williamson broke a cardinal rule, one that my co-blogger Scott Sumner loves to cite: "Never reason from a price change." An interest rate is a price of current availability of resources. If you start by reasoning from a price change, you forget to ask why the price changed.

And that stricture about the direction of reasoning matters in this case. The correct statement of the Fisher effect is NOT that "a reduction in the nominal interest rate reduces inflation." The correct statement is that a reduction in expected inflation, all other things equal, reduces the interest rate.


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CATEGORIES: Money , Regulation , Taxation




COMMENTS (20 to date)

David Henderson writes:

… a cardinal rule, one that my co-blogger Scott Sumner loves to cite: "Never reason from a price change." … If you start by reasoning from a price change, you forget to ask why the price changed.
I have wanted to understand Scott's "Never reason from a price change." So I appreciate your explaining it in one clear sentence.

Does the regress end? Suppose we do remember to ask and we get an answer: X caused the price change. Can somebody ask what caused X?

Am I correct that you expect the line of questioning to end with some satisfying exogenous (outside the economic model) event or shock?

Jerry Brown writes:

At least you allow that terrorism is a bad thing. I don't want to get rid of cash, but in general, it is better for societies to work to change laws and regulations that are unjust, rather than make it easier to skirt them.

David R. Henderson writes:

@Richard O. Hammer,
I have wanted to understand Scott's "Never reason from a price change." So I appreciate your explaining it in one clear sentence.
Good.
Does the regress end?
Good question. I’m not sure. What’s special about prices, though, is that we can narrow the causes down to only two: shift in supply or shift in demand. (That simplifies a little because even with neither shifting and even without costs changing, a price searcher might get experimental.)
Suppose we do remember to ask and we get an answer: X caused the price change. Can somebody ask what caused X?
Yes.
Am I correct that you expect the line of questioning to end with some satisfying exogenous (outside the economic model) event or shock?
Exogenous, yes. Outside the model, not necessarily. Look back at about 1965 or 1966, when the Pope announced that Catholics could eat meat on Friday. We’re fairly confident that the effect was a downward shift in demand for fish, and we’re fairly confident, although slightly less so, that the Pope didn’t make this announcement because of either an increase in the price of fish or a decrease in the price of meat. The decline in demand for fish is exogenous, but it’s inside the model.

JP Koning writes:

Hi David,

You touch on the role of cash in the drug trade, corruption, and terrorism. What about human trafficking, kidnapping, and extortion?

When it comes cash's usefulness in enabling tax evasion you make use of the Leviathan argument, but what do you think about Rogoff's claim that cash introduces a horizontal equity problem--it allows some people to avoid paying taxes and thus forces law-abiding people to pay more than their share?

Rogoff also mentions the efficiency case for removing high denomination notes. If taxes can be avoided in cash-intensive businesses, then too much investment will go to them, say compared to a business that has higher pre-tax returns but lower post-tax returns. Thoughts?

David R. Henderson writes:

@JP Koning,
You touch on the role of cash in the drug trade, corruption, and terrorism. What about human trafficking, kidnapping, and extortion?
I “touched” on them because Williamson did. Obviously, cash facilitates lots of crimes that you and I would like to have fewer of. BTW, though, the term “trafficking” has almost lost its meaning. Government officials are increasingly referring to voluntary prostitution by adults as involving trafficking.
but what do you think about Rogoff's claim that cash introduces a horizontal equity problem--it allows some people to avoid paying taxes and thus forces law-abiding people to pay more than their share?
I think there’s something to it.
Rogoff also mentions the efficiency case for removing high denomination notes. If taxes can be avoided in cash-intensive businesses, then too much investment will go to them, say compared to a business that has higher pre-tax returns but lower post-tax returns. Thoughts?
True.

mariorossi writes:

Whenever I read your writing I always wonder if you believe in prisoners' dilemma.

While I don't disagree that evading taxes or paying bribes could be efficient in certain very specific circumstances, the ability to extract bribes can also be a powerful incentive for politicians to pass strong regulation, so I don't think that's a very persuasive argument. The same can be said for high taxes: they generate the opportunity to extract bribes to avoid them.

It seems to me a case of free-rider/prisoners' dilemma.

A pretty standard solution to prisoners' dilemma type situation (and I believe the most efficient one) is to remove the freedom to defect. Surely even libertarian concede that there are a few circumstances where that's the best solutiuon...

Miguel Madeira writes:

I suspect that "human trafficking" is little more than a particularly scary way of saying "illegal immigration".

Shane L writes:

In the last year I have seen increased antipathy by many on the left and right for the institutions of developed countries like the US and UK, involving attempts to distort the political system by rival political groups when they fear electoral defeat. Your suggestion that corruption and tax evasion could be beneficial in reducing onerous regulation or taxation for business reminds me of this.

Is there no benefit to having rule of law: a system of well-understood rules to which we all adhere, rich or poor, powerful or weak, with known penalties for criminality? If people lose faith in the system entirely because they see others cheating it through corruption, I don't expect libertarianism. I expect crime, riot, revolution and possibly the emergence of much worse governance by brutal warlords. It seems far preferable to work within the system, promoting drug legalisation, less onerous regulation and less taxation. Cheating the system sends a negative signal to everyone: that you probably should not bother obeying the law or paying taxes because other people aren't.

Matthias Görgens writes:

Cash or not doesn't make a difference to taxing land value; and that's where any sane economy would get the most of their tax revenue from.

You can't hide land. And if you don't pay your taxes, it's easily seized.

So the whole tax argument against cash is pretty much moot, even if one was to accept that more tax revenue is good.

David R. Henderson writes:

@mariorossi,
Whenever I read your writing I always wonder if you believe in prisoners' dilemma.
You need wonder no more. I do.
the ability to extract bribes can also be a powerful incentive for politicians to pass strong regulation,
True, which is why I quoted the paragraph from the Corruption article that says that.
So while you wonder whether I believe in the prisoner’s dilemma, I wonder how carefully you read.

David R. Henderson writes:

@Shane L,
Is there no benefit to having rule of law: a system of well-understood rules to which we all adhere, rich or poor, powerful or weak, with known penalties for criminality?
There’s a huge benefit.
It seems far preferable to work within the system, promoting drug legalisation, less onerous regulation and less taxation. Cheating the system sends a negative signal to everyone: that you probably should not bother obeying the law or paying taxes because other people aren't.
So are you saying, Shane L, that if you badly wanted to ingest marijuana [and I’m not saying you do], you would not do so even if you could get away with it?

Scott Sumner writes:

Excellent post, especially the argument that the existence of an underground economy tends to restrain the leviathan.

Shane L writes:

So are you saying, Shane L, that if you badly wanted to ingest marijuana [and I’m not saying you do], you would not do so even if you could get away with it?

Well David, I've never taken illegal drugs so I don't know how badly I would want to - maybe pretty badly! Broadly speaking I do think people should certainly not buy illegal drugs when their illegality means that only criminal gangs are selling. It amazes me to see friends casually funding murderous gangsters by buying drugs to have fun with. If someone wanted to grow a small amount of marijuana in their own home for their own use I would not object too much. Perhaps this is an inconsistency in my approach. (Similarly I never objected in the days of cassette tapes of people making mixed tapes for their friends, etc. but I have a bit more concern for the massive downloading of films and music for free in the internet age. I understand that there's a bit of moral inconsistency on my part there!)

Nevertheless I feel ambiguity in the adherence to rules is unhelpful. Developing countries that lurch from dictator to chaotic civil war to dictator are often characterised by this general contempt for the democratic political institutions (not to mention corruption and wealthy elites who pay no taxes). In some cases the rules may be simply abhorrent - deliberate violent discrimination against a minority group for instance - but I can't imagine self-serving cheating, tax-dodging, and corruption is likely to lead anywhere good. Fascinating idea though: are there countries that aren't corrupt enough?

David R. Henderson writes:

@Shane L,
First, I appreciate your willingness to address these issues seriously and to admit that you might have some moral inconsistency.
Second, I think that you’ve shifted, perhaps unintentionally, the discussion away from the issue you started with. My guess, by the way, is that many buyers of illegal drugs are funding criminal gangs that do not murder. I tend to see murder as something that happens when certain contractual arrangements break down and so it’s the exception rather than the norm. But I admit that I don’t know that.
So let’s get back to rule of law. Some people who use marijuana grow their own. So they are breaking the law, and that, I gather, concerns you. But they are not funding murderous gangs. So, in that case, would you say they’re wrong to break the law and that you wouldn’t, even if you badly wanted marijuana, buy from them?
Also, to put all this in perspective, by earning a lot of money, I give a lot of money every year to one of the biggest murderous gangs in the world, as one of my military officer students pointed out to me some years ago. The murderous gang I “give” to even has a kill list and is now busy killing people in 7 countries--and those are just the ones we know about.

David R. Henderson writes:

@Scott Sumner,
Thanks, Scott.

Andrew_FL writes:

Every "macroeconomist" surely knows Fisher's identity defining the nominal rate of interest as the sum of a real rate and an inflation premium.

His assertion that every "macroeconomist" "knows" his interpretation of that identity is distinctly odd, given he interprets the inflation premium in a manner exactly backwards from how economists have understood it ever since Fisher defined the concept.

Sam P. writes:

The supposedly shocking fact that there is $4,200 in US currency in circulation per US resident is not shocking at all when one considers that much of that currency is held outside the US. Further, the anti-cash argument seems to slide too easily to the assumption that such cash holdings have an illegitimate purpose. In fact, the US dollar is regarded, rightly or wrongly, as among the soundest in the world. Thus, it is not surprising that people in other countries might want to diversify their currency holdings to include dollars.

The anti-cash argument also fails to examine just why large denomination bills might be favored by criminals. One would suppose that it is because a given sum can be transported more easily because the sum will be lighter and more compact in large denomination bills than in small ones. But this advantage can be at least partially offset by making such bills much larger and much heavier. (The ability to better distinguish bills from one another is a great benefit currently lacking in US currency.)

Finally, the extreme anti-cash argument fails to adequately consider the privacy effects of forcing all transactions to be electronic and thereby to be revealed to third parties, including hackers.

Roger McKinney writes:

Outside the US, the $100 bill is the main tool of savings for poor people. I would guess that is true within the US. A lot of Latino immigrants don't have bank accounts and keep large amounts of cash at home. It's just typical of academics like Rogoff that he knows nothing about the poor and probably couldn't care less.

mariorossi writes:

I don't think I explained my point properly.

I see the "Corruption" article making the opposite point I was trying to make.

I am trying to point out that there is a possible opposite effect: by making paying bribes possible, cash could increase the chance of harmful regulation. Without a way to extract value, politicians might be less inclined to pass bad laws as they would not benefit from them.

I don't want to oversell the argument (as you can always envisage methods to extract bribes that don't involve cash), but there could be something to it.

David R. Henderson writes:

@mariorossi,
I don't think I explained my point properly.
You made your point properly.
I am trying to point out that there is a possible opposite effect: by making paying bribes possible, cash could increase the chance of harmful regulation. Without a way to extract value, politicians might be less inclined to pass bad laws as they would not benefit from them.
I got that. Which is why I replied the way I did. The quote from the Corruption article makes the point you make. Read the whole paragraph I quoted. It’s not long.

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