Do High-Denomination Notes Create Externalities?

In J.P. Koning’s lead essay he outlines the costs and benefits of large denomination currency and proposes the introduction of a high-value “supernote” that would be taxed to deal with the externalities imposed by high denomination users. Koning’s proposal is similar to the optimal policy suggested in my own work with my colleague, Jaevin Park. It should therefore come as no surprise that I would support his policy proposal on the condition that we accept the premise that there are externalities imposed by the use of currency.

However, I am not completely convinced by that premise. As such, I would like to organize my response around three points. First, I will push back on the idea that the use of currency creates an externality in the traditional sense that we use the term. Second, I will argue that the elimination of high denomination notes would do little to reduce illegal transactions. And finally, I will argue that even if we accept the premise that currency creates an externality, the optimal policy would not be to eliminate high denomination notes, but rather to enact the sort of policy that Koning proposes.

A common argument made by those advocating the elimination of high denomination notes (or currency, entirely) is that currency is used in illegal trade and therefore creates an externality that needs to be corrected by public policy. This argument is predicated on a different view of externalities than is typically found in the literature. For example, pollution is a textbook example of an externality. A firm that generates pollution as a byproduct of production does not bear the full cost of the pollution. Since the pollution can affect air quality and/or the health and production of others in society, the firm is creating an external cost above and beyond the cost of its own production. It is important to note that the cost to society is not the mere annoyance of seeing clouds of smoke or murky water, but rather the health and productivity consequences of pollution. It is unclear whether the sort of illegal activity that is facilitated by currency fits the same model as something like pollution.

An externality is not simply any action that imposes a cost on others. If a new restaurant opens up across the street from an existing restaurant, the incumbent might incur a cost in the form of lower profits. However, this is not an externality that requires a public policy solution. Thus even if an activity is made illegal precisely because a vast majority of the population considers the transaction to be morally abhorrent, this does not necessarily imply that there is an externality. Pearl clutching, like foregone profits, are an external cost. Nonetheless we do not compensate firms for foregone profits, and therefore it is unclear whether mere distaste requires any sort of compensation. To the extent to which illegal trade is said to generate an externality, the external costs of such transactions are likely overstated.

Even if we accept the idea that the sort of illegal trade facilitated by currency generates an externality, there is no guarantee that eliminating currency (or the large denomination variety used in large-scale illegal transactions) would eliminate such trade. With respect to illegal trade, currency is a means to an end. Eliminating the means hardly guarantees an elimination of the end. Instead, those who are already engaged in illegal transactions are likely to look for substitutes. The recent emergence of cryptocurrency would likely get a boost from the elimination of large denomination conventional currency. Furthermore, those engaged in illegal activity might be inclined to create their own media of exchange or payment system.

All of this is not to mention the fact that currency (even large denomination currency) is used by many people for legal transactions. Eliminating large denomination currency therefore imposes a cost on the law-abiding members of society. This subtracts from any perceived net benefit of eliminating illegal trade. Overall, this suggests the net benefits of eliminating large denomination currency are likely exaggerated as well.

This brings me to my final point. Suppose that we simply take as given that illegal trade reduces social welfare, and that large denomination currency facilitates that type of trade. What should be done? What is the optimal policy? A typical Pigouvian response to this sort of problem is to levy a tax on the activity that creates an external cost. The proceeds of the tax can then be transferred to the harmed group. The problem with this type of policy solution is that illegal trade tends to be hidden and unreported and is therefore difficult, if not impossible, to tax.

The fact that large denomination currency has desirable properties for engaging in illegal activity, however, allows for a possible solution. As my colleague Jaevin Park and I show in our paper “Breaking the Curse of Cash,” the optimal policy in this sort of environment is to have two types of currency with a flexible exchange rate between the two currencies. Policymakers can then vary the rates of return (or the rates of depreciation) on each currency to induce legal traders to hold one type of currency and illegal traders to hold the other type. The seigniorage earned from depreciating the currency used by illegal traders can then be used to finance a transfer to legal traders. By introducing a separate type of currency, policymakers are able to engineer a Pigouvian policy.

The policy suggested by J.P. Koning in his original post is precisely the sort of policy consistent with our model. He argues that the United States should create a supernote and institute a surcharge (tax) on this supernote such that it depreciates faster than smaller denominations. If the tax is set optimally, this scheme would effectively replicate the result from our paper. To the extent to which we want to reduce illegal activity facilitated by cash, this is an appropriate policy to do so.

Also from this issue

Lead Essay

  • J. P. Koning looks at the world of high-denomination currency. Per American, there’s way more of it in circulation than even very rich Americans typically see. Much of it is undoubtedly used in crime and under-the-table transactions, which escape the tax system and impose in-effect taxes on the rest of us, who must make up the shortfall as fraudsters evade taxes. Koning proposes to issue high-value notes that would gradually depreciate as a way of tackling this tricky problem.

Response Essays

  • James McAndrews suggests that issuing paper money with a high but gradually decreasing value might not work out well. The demand for high-value paper is large, but much of it comes from illicit enterprises, who might be willing to use force to extract value from their clients. Confusion could lead to disuse at best and to fraud at worst. But the $100 bill isn’t worth what it used to be, and in response he suggests issuing a $200 bill.

  • Joshua R. Hendrickson says that maybe high-denomination notes aren’t creating externalities in the proper sense of the term. The fact that some people don’t like off-the-books transactions does not mean that they impose actionable costs on bystanders. But if we grant the claim for the sake of argument, then a two-tiered currency with depreciation of higher-denomination notes would indeed be wise.

  • William J. Luther argues that we shouldn’t tax currency at all. We should modestly reward holding it, through a bit of deflation. Luther doubts the extent of tax evasion and other crimes committed though the use of cash. He also argues that many prohibited uses of cash, including off-the-books employment, are ubiquitous, harmless to others, and do not merit any punishment or disincentive.