Lukas Püttmann    About    Blog

Denomination capping as coordination game - and implementation troubles

So the ECB is getting rid of the 500 euro note.

I see the point for convenience in buying a car in cash and some people might like to store their wealth in physical banknotes or make transactions in cash. But for most that’s not advisable anyway and it makes it things too easy for criminals. Also, in many countries in Europe there is already a limit on how large cash transactions may be. So I guess I see the point for getting rid of the 500 note, but I’m not quite ready to side with economists like Kenneth Rogoff who argues for abolishing cash altogether.

The profits from seigniorage that come from this underworld business should be quite large. The drug lord Pablo Escobar stored his wealth in the ground in dollar notes in Colombia and he reportedly lost 10% of his wealth every year due to “depreciation”. So if these notes were just by rats (and not stolen and spent somewhere else), then this amounts to an annual 10% tax for the United States government on Escobar’s wealth.

A similar thing is at play when bank notes from one country are used in another. Whether they are held by the Russian mafia to store wealth or by Cambodian shopsellers to trade, dollars in circulation in another country are a direct source of income for the United States government. The reason is that the Federal Reserve can print more money and exchange it for goods without pushing up domestic inflation.

So countries looking for higher seigniorage revenues have an incentive to have high denomination banknotes to tempt criminals in other countries to use their currency. Maybe it’s not a coincidence that the countries with the highest denominations are Switzerland and Singapore? So seen from that angle, capping the denomination of banknotes is a coordination game among countries.

The ECB’s decision to end usage of the 500 euro note might be a good idea, but is difficult to implement properly. For once, the stop is not immediate and, secondly, the existing 500 euro notes in circulation will keep their worth infinitely.

They’ll stop giving them out by the end of 2018. So until then, people can convert as much of their cash into 500 notes as they wish.

Will there be a second market for 500 notes after 2018? A large number of 500 euro notes are outstanding. People might hold on to them for years. But bank notes aren’t made to last forever, so they’ll probably be used until they are worn down and at that point somebody will exchange them at a bank for different denominations.


Update: Lawrence Summers thinks the ECB’s policy makes sense but is just a start:

First, the world should demand that Switzerland stops issuing SFr 1,000 franc notes. After Europe’s bold step, these notes will stand out as the hard-currency world’s highest denomination note by a wide margin. Switzerland has a long and unfortunate history with illicit finance. It would be tragic if it were to profit from criminal currency substitution.

And I would add that it’s not just “substitution”, but benefiting from it through seigniorage.