JIM RICKARDS: FREE TRADE A BARBAROUS RELIC

 

Jim Rickards’ most recent book, The Road to Ruin, has been his most provocative, following a stream of works that has gotten the attention of pundits and investors alike. There are many compelling aspects of his books, but the focus of this paper will be on the controversial topic of free trade, which Rickards covers in his latest one, and why he is mistaken in denying its validity in our modern economy. While he is generally supportive of free market principles, global free trade is not one of them.

The section titled” Apple and the Cat” in Chapter 7 starts with the concept of comparative advantage, which is the underlying foundation for free trade. In the current paper, there is no need to restate or analyze this theory since the author claims it’s validity in and of itself:

The issue is not that Ricardian theory is wrong; it’s that the theory relies on assumptions that don’t conform to the real world, and is therefore useless as a guide to policy.

He sees the principle as being susceptible to exogenous barriers that didn’t exist at the time of the principle’s formulation by David Ricardo. These non-market forces manipulate the mechanism of pricing and allocating production and labor, to the detriment of domestic growth and employment. It is necessary to take the author’s arguments against free trade and dissect each claim. This will prove that comparative advantage is universally valid regardless of any intervention that attempts to interrupt its process.

After summarizing comparative advantage, Rickards makes his first overall critique by stating that the concept is based on a “network of factors of production, costs, prices, markets, and money”, and outside distortions caused by international central banks and governments prevent this from doing its job. These prices and costs are ‘imperfect’, in that they aren’t reliable in allowing market actors to properly calculate profits and losses with precision.

He makes a fundamental mistake by thinking prices, barring any government intrusion, are ‘perfect’ in a sense. Prices are merely exchange ratios between goods and services on one hand, and money on the other. Information is imbedded in each price, providing the necessary data on the availability and desirability of each product. This information is almost never perfect, in the sense of being ‘correct’ with regard to prices businessmen charge and pay for labor and capital. If it were, we would be in what economists refer to as equilibrium where subjective expectations allow supply and demand to equalize and therefore profits be eliminated in the economy.

Rickards also critiques the model known as General Equilibrium earlier in his book, but this topic and it’s relation to the purpose of this paper won’t be covered here. Suffice it to say that his first general statement on the short comings of comparative advantage ignores the fact that our domestic economy also faces distorted and imperfect prices and signals for the same reasons (price controls, currency manipulations, government barriers, etc.), and yet the U.S. has seen the size of its economy triple in real terms since the early 1970’s, in addition to the number of jobs doubling, outpacing population growth in the civilian workforce. Any price distortions present since then have failed to prevent the tremendous increase in our real wealth. Rickards doesn’t seem to grasp that the domestic economy is ruled by the same economic laws as the international economy. Prices and production can be distorted, but the price mechanism always finds a way around barriers and flourishes in the end.

While this is the foundation of this paper’s argument, it is general yet not sufficient and further inquiry is necessary to show the flaws in his work that flow from his misunderstanding of price comparisons in the global economy. Before continuing, it must be said that despite the book’s claim that comparative advantage is supported by the ‘neoliberal consensus’ and elitist supporters of globalization(the definition of which is fuzzy and often misunderstood), it can be easily shown that heterodox economists also have unfaltering support for this principle.

A comparison is drawn by the author between comparative advantage with floating exchange rates as well as with the classical gold standard. In the latter, where a dollar was defined as a specific weight of gold, international prices fluctuated but prices allowed countries to properly make reasonable comparisons due to their monetary authorities linking their currencies to gold. This system contained what economists know as the price-specie flow mechanism, originally conceived by Richard Cantillon (Rickards wrongfully attributes this to David Hume in his previous book). Floating exchange rates, on the other hand, allow for price comparisons in so far as these rates are not influenced by exogenous forces with the intent to manipulate relative prices, costs, or interest rates. Unfortunately, according to the author, this occurs quite often in bilateral and multilateral ‘currency wars’, where central banks attempt to devalue the domestic nation’s currency with the goal of stimulating exports, employment, and growth.

This is overall a reasonable summary of both monetary systems, but some qualifications must be made to display confusions on Rickards’ analysis and solutions. First, it is true that currency hedges, which allow businesses and exporters to protect themselves from such devaluations, are typically only are available for 1 year contracts. However, this can be bypassed by rolling over these contracts when they are close to maturing, thus allowing capital investment to be implemented for longer periods while reducing the effect of devaluations on a company’s profits and costs.

Second, he defends the Bretton Woods international monetary system(1944-1971), stating it was a “golden age of growth and higher real incomes.” While this cannot be refuted on a statistical level, this regime was not without defects once one looks past the abstract data, and this paper will certainly argue that a monetary system of any kind can be seen as a success only if it 1) benefits society in terms of general well-being and 2) is sustainable. The former is not debatable, but there are several points to be made on the latter.

THE DEATH OF BRETTON WOODS

This fixed exchange system really wasn’t one system for 27 years. Economists generally divide it into two periods due to the convertibility of the national currencies within the Bretton Woods system. From 1946 to 1958 current accounts were partially restricted between Europe, Japan, and the U.S due to the dollar shortage (the U.S. held over 2/3 of the world’s gold reserves at the time). This meant that the currencies of the trading nations weren’t fully convertible until early in 1959, making it fully operational from 1959 until 1971 when Nixon closed the gold window. What Rickards didn’t acknowledge was that while this regime reduced exchange rate volatility (thus making trade more efficient and robust), it was not sustainable in a political sense. In the current economic system, it is impossible to separate politics from economics.

Looking at the second period of the Bretton Woods system, it is clear to see that U.S. budget deficits were, on average, much larger during this period where full convertibility between currencies allowed it to function properly and fluidly, particularly during the latter half of the 1960’s.

 

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This in contrast to post-war Europe and Japan, where the lack of dollars held forced the U.S. to run current account deficits in order to provide enough liquidity for these countries to convert U.S. dollars into gold. Thus, inflationary policies increased the general ‘price level’, and the prices of U.S. exports, allowing other countries to run balance of payments surpluses, accumulating dollars abroad. What’s important about this point is that as these countries continued to accumulate dollars as reserves, and as the U.S. continued to pursue inflationist policies, the more they realized the value of their dollar holdings would deteriorate, thus incentivizing them to convert their dollars into gold.

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What Rickards ignores is that as these dollars were being accumulated abroad(voluntarily as countries attempted to increase their reserve balances), the attempt to prevent the fall of the dollar’s value by the U.S. government through foreign investment disincentives, restrictions on foreign lending, efforts to stem the official outflow of dollars, and cooperation with other countries did not succeed(in addition to foreign trade restrictions). Inflation was beginning to rise by the late 60’s, approaching 6% , as was the gold outflows from the Treasury. In fact, it can be shown that the domestic gold stock began to plummet in 1959, in the beginning of the convertible phase of the Bretton Woods system.

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An important distinction with these trends cannot be ignored, as Rickards has done. It seems he mistakes a system of price-fixing for a free market. The official price of gold was at $35 per ounce since 1933, and the settlement of trade imbalances in the Bretton Woods agreement was made exclusively by central banks. This was a price ceiling on gold, a form of government price control the government was willing to defend that could only lead to a devalued dollar. The central banks would not allow a rise in their currencies’ value. This is the motivation behind mercantilism. In addition, this agreement was political, not self-correcting or based on price discovery as the classical Gold Standard was. Gold settlements were to only be made between central banks, not citizens.

The London gold market, on the other hand, was a considerable vestige of the free market, where investors and speculators(as well as official institutions) could buy and sell gold in a parallel, yet more private exchange system. The fear of the banks was that private forces would anticipate the drop in value of the dollar from chronic U.S. budget deficits to cover the expenses of the Vietnam War and other inflationary government spending. This turned out to be true, with the London gold price rising to $40 per ounce in 1960. Foreign central banks could also dip into the London gold market and purchase gold instead of taking a political risk by going to the gold window at the U.S. Treasury.

While this was certainly a possibility, the U.S. government had temporary success convincing foreign central banks to not redeem their excess holdings of short-term dollar reserves in exchange for gold. However, they could not stop speculators from betting against the dollar by buying gold in the free market in London.

Despite several central banks, including the Federal Reserve, establishing the London Gold Pool in 1961 and pledging significant amounts of their own gold to it (the U.S. contributed 50% of the total gold pool), the continuous budget and balance of payment deficits, as well as the superfluous military spending by the government caused a run on the gold stock by both speculators and eventually other central banks. The value of the gold held by the U.S. Treasury in 1949 was $25 billion. Ten years later, it possessed roughly $22.8 billion. That number dwindled to $12.4 billion by 1967. And just one year later, that amount decreased even more steeply to $10.3 billion. The London Gold Pool was thus shut down by President Johnson due to the extreme outflow of gold due to foreign central banks (mainly France and Switzerland) redeeming their dollar holdings. This eventually led to President Nixon eliminating the link between gold and the dollar in 1971.

Looking again at the money supply numbers, it can be seen that M1 had doubled from $111.9 billion in 1947, to $225 billion in 1971. This amount was relatively similar to the fall in gold holdings of the Treasury during virtually the same period. When put into context, the increases in the money supply are similar in scope as in any other multi-decade period in U.S. history. The mere existence of a pegged rate between gold and a reserve currency such as the dollar and the euro, while only allowing central banks access to exchanges, does not prevent manipulation and distortion of the kind Rickards attributes to the present international monetary nexus.

Thus, Rickards overlooks the sustainability of a system that, while providing a stable fixed-rate environment for international pricing, could not last due to the simple fact that the temptation for governments and politicians to overspend while using their central banks to enable such spending and budget deficits is too great. And while ‘free trade’ paired with floating exchange rates that are manipulated by protectionist central bank policy to stimulate exports is not a viable solution either, calling the Bretton Woods regime a “golden age” as the author has done cannot be taken seriously. His distinction between fixed and floating exchange rates is a false dichotomy. The real choice is between government fiat money, and a true free market in money, allowing citizens to choose what currency(s) provide the best stability and network effects, allowing them to avoid any such monies that tend to be susceptible to devaluation of the sort that troubles Rickards(and the current writer as well). The private banking system can sort out the type of monetary framework that can work in a free market.

MANUFACTURING TOO FAR GONE

The next problem Rickards sees is with the fall in manufacturing and high-value jobs since the early 1970’s. His claim is that protectionism created the “greatest industrial juggernaut the world has ever seen”, and since then the valuable jobs associated with our manufacturing base have been siphoned off by the unfair protectionist policies of Asia, particularly China and Japan. This is a classic post hoc ergo propter hoc fallacy the author commits. In this section, economic history will be the focus, since the author makes several false claims as to the origin of our current economic environment.

To start, one should question the dubious claim that manufacturing has decreased in any real sense. The problem with his assessment perhaps stems from his tendency to look at production from a physical standpoint instead of a subjective value standpoint, which is economically more relevant. To be sure, the total real output of manufacturing has been rising significantly in the past few decades. It nearly hit an all time high in 2015, with the output of durable goods three times higher than it was in 1980.

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And the value of each worker’s output has risen proportionately as well.

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When this rise in value output is compared to other major countries, it is seen that the U.S. is not in any “seventy-year decline” as Rickards states.

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As a matter of fact, according to economists John W. Kendrick, Robert E. Gallman, and Thomas J. Weiss, both the output and labor force associated with manufacturing and industry have actually been lower than service sector output since at least 1840.

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Instead of taking Rickards’ unsubstantiated claim that the fall of manufacturing and industry was caused mainly by currency manipulation and protectionism from countries like China, we find that manufacturing as a percentage of the total U.S. economy was never really the dominant force relative to the service sector as is widely believed. However, further inquiry is needed to determine the cause of the fall in the amount of jobs in manufacturing and industry, especially since it is obvious that output in both physical and value terms has risen in recent decades.

We can see clearly that private-sector employment for the production of goods, with manufacturing included, in the private sector as well as a percentage of total private-sector employment has fallen steadily since World War ll. This fact will be applied to our discussion below after wages and income for both manufacturing and the economy in general are dealt with.

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It’s often said by pundits and political commentators that wages in the U.S. have been stagnant for the last few decades. This is a mistake in methodology. Economist Don Boudreaux has recently found that wages have not “decoupled” from productivity(which has risen exponentially), despite Rickards’ claims:

The illusion is the result of two mistakes that are routinely made when pay is compared with productivity. First, the value of fringe benefits—such as health insurance and pension contributions—is often excluded from calculations of worker pay. Because fringe benefits today make up a larger share of the typical employee’s pay than they did 40 years ago (about 19% today compared with 10% back then), excluding them fosters the illusion that the workers’ slice of the (bigger) pie is shrinking.

The second mistake is to use the Consumer Price Index (CPI) to adjust workers’ pay for inflation while using a different measure—for example the GDP deflator, which converts the current prices of all domestically produced final goods and services into constant dollars—to adjust the value of economic output for inflation. But as Harvard’s Martin Feldstein noted in a National Bureau of Economic Research paper in 2008, it is misleading to use different deflators.

Different inflation adjustments give conflicting estimates of just how much the dollar’s purchasing power has fallen. So to accurately compare the real (that is, inflation-adjusted) value of output to the real value of worker pay requires that these values both be calculated using the same price index.

Consider, for instance, that between 1970-2006 the CPI rose at an average annual rate of 4.3%, while the GDP deflator rose only 3.8%. Economists believe that such a difference arises because the CPI is especially prone to overestimate inflation. Therefore, much of the increase in the real purchasing power of workers’ pay is mistakenly labeled by the CPI as mere inflation.

Mr. Feldstein and a number of other careful economists—including Richard Anderson of the St. Louis Federal Reserve Bank and Edward Lazear of the Stanford University Graduate School of Business—have compared worker pay (including the value of fringe benefits) with productivity using a consistent adjustment for inflation. They move in tandem. And in a study last year, João Paulo Pessoa and John Van Reenen of the London School of Economics compared worker compensation and productivity in both the United States and the United Kingdom from 1972-2010. There was no decoupling in either country.

https://www.wsj.com/articles/donald-boudreaux-and-liya-palagashvili-the-myth-of-the-great-wages-decoupling-1394151793

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This sentiment is also echoed by James Sherk of the Heritage Foundation in a working paper on wage compensation. Here is the abstract:

Conventional wisdom holds that worker productivity has risen sharply
since the 1970s while worker compensation has stagnated. This belief
rests on misinterpreted economic data. Accurate and careful comparisons
show that over the past 40 years measured productivity has
increased 100 percent and average compensation has risen 77 percent.
Inflated productivity measurements account for most of the remaining
23 percentage point difference. An apples-to-apples comparison shows
that employee compensation continues to closely follow productivity.
American workers continue to earn more as they become more productive.
To help Americans advance economically, policymakers should
seek policies that will increase productivity.

http://thf_media.s3.amazonaws.com/2013/pdf/bg2825.pdf

This shows that Rickards does not take into account these factors which is surprising considering his in-depth focus in each of his books on the effects of inflation in terms of wealth distribution and accumulation. To be clear, his motivations are not being questioned here, just his methods for analyzing data and the inconsistencies that his newest book shows. In addition to this wage-productivity analysis , Boudreaux and other economists have found a similar trend in U.S. income distribution.

Since the early 1970’s, the percentage of middle class and lower class households dropped considerably, while wealthier income households more than doubled between 1975 and 2009. Thus, more people have been moving to higher income brackets. This can only mean wage and income mobility is 1) due to higher value productivity and 2) becoming more flexible making upward movements less difficult for former lower-income families to obtain higher standards of living. Thus the claim by Rickards that the middle class is stagnating due to job losses and wages not rising is clearly not true.

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The question remains however, of why employment in the production of manufactured goods and exports have fallen while the total value of output and incomes of those workers still in those markets has risen exponentially. The answer is actually quite simple. Productivity gains from improvements in information technology and automation have allowed workers to create more output with an increase in the amount of capital accumulated. Thus, fewer workers are needed to create the output necessary for businesses to compete. According to a study done by Michael J. Hicks and Srikant Devaraj of the Center for Business and Economic Research at Ball State University:

Three factors have contributed to changes in manufacturing
employment in recent years: Productivity, trade, and domestic
demand. Overwhelmingly, the largest impact is productivity.
Almost 88 percent of job losses in manufacturing in recent years
can be attributable to productivity growth, and the long-term
changes to manufacturing employment are mostly linked to the
productivity of American factories…

Exports lead to higher levels of domestic production and employment,
while imports reduce domestic production and employment.
The difference between these, or net exports, has been negative since
1980, and has contributed to roughly 13.4 percent of job losses
in the U.S. in the last decade. Our estimate is almost exactly that
reported by the more respected research centers in the nation.

http://conexus.cberdata.org/files/MfgReality.pdf

Putting these facts into context, there’s no denying that U.S. wages, when fringe benefits and proper inflation adjustments are accounted for, reflect manufacturing and productivity gains since Rickards’ aforementioned period of higher growth and incomes ending in 1971. This flies in the face of his assertions that free trade is an obsolete concept which no longer applies to international economics. Protectionism did not play the huge role he claims that turned the U.S. into a dominant economic power because manufacturing has composed a relatively small part of the U.S. economy since at least the middle of the 1800’s. And while currency manipulation may have a negative effect on trade flows and export markets, it’s obvious that the areas of the market most affected by this can not only breathe, but flourish regardless of foreign protectionist barriers and currency wars. However, there are still some discrepancies in his economic analysis that need to be rectified.

THE FETISH FOR JOBS AND GROWTH

Abstracting from the previous analysis, there are numerous other errors and fallacies that Rickards proposes as truth to his readers. To start, this paper must point out what was briefly mentioned earlier. And that is he seems to mainly focus on lost jobs and China when discussing the detriments of globalization and protectionism. He states:

Even if one accepts that there will be winners and losers in a global trading system, what happens when the number of winners is few, and the losers are many? The answer is lower labor force participation, lower productivity, stagnant wage gains, and greater income inequality.

When the transfer of input factors is complete, comparative advantage is lost forever. The United States is left with dead-end jobs or no jobs at all.

The claim by Rickards of lower productivity and stagnant wages has already been refuted. However, labor participation is often cited as a problem of our shifting economy and supposedly indicates that many capable people are dropping out of the workforce. Fortunately, this has more to do with demographics than free trade. The trends we are seeing are that older citizens are retiring in larger numbers and women in general are choosing not to work as much as they did in the past. In addition our youth are extending their educations and going to college, sometimes for longer periods. He is a report from the Bureau of Labor Statistics:

http://www.factcheck.org/2015/03/declining-labor-participation-rates/

This follows the basic premise that markets tend to adjust. Rickards connects this lower rate to the manipulation of free trade. But there is a problem with this. There is no shortage of jobs. We live in a tremendously intricate division of labor, and that system is constantly changing. Jobs are being added or changed, or sometimes even becoming obsolete. But to think that the number of jobs in the U.S. are somehow “fixed” is a fallacy. Economist Richard Ebeling writes:

Now labor, too, is not homogeneous and interchangeable. (To view it as so is to commit the “lump of labor” fallacy.) In an intensive capital using market economy, an inevitable complement is a growing specificity of skills and experience within the “labor supply.” A medical doctor is not an interchangeable substitute for the knowledge skills of a lawyer, or an accountant, or an economics professor, or a computer programmer, or an auto mechanic, or an interior decorator, or a hair stylist, or . . .

Since labor is part of a heterogeneous structure of inputs, there are costs involved with refitting and reorganizing proportions of labor with capital in order to create new products or improve old ones, thus creating new ways to improve this structure of production. Rickards pays lip service earlier in his book on the “varied and diverse” forms of capital and labor especially, but fails to apply this statement when looking at jobs as an aggregate concept. The main point is that there is always work to do since diverse desires and demands are never truly satisfied in an economic sense. The lump of labor fallacy (as well as comparative advantage) is a topic that Austrians, Monetarists, Keynesians, and Neoclassicals all typically agree on, and many members of each school can certainly not be described as “neo liberal” or “elite globalists” as Rickards states.

He then proceeds to mention that the kind of labor that doesn’t provide positive externalities are what the U.S. is left with due to other countries manipulating free trade:

Certain jobs persist yet go nowhere, and do not drive growth. A barista may have a steady job at decent wages, but that’s all … Lego-style assembly jobs are not, without exogenous effects, a source for additional jobs.

There are several faults one can find in just these few sentences alone. The first is the concept of externalities. It’s true that businesses in foreign countries often create negative outcomes with questionable production techniques (Rickards’ example of China dumping cyanide into rivers is a legitimate concern), and that is inexcusable. But to deny the existence of positive externalities with service sector jobs ignores a concept called derived demand. When someone becomes a barista or a retail clerk, they instantly provide new effective demand in the market(Say’s Law). For example, if they demand a new pair of tennis shoes, that means the demand for all of its inputs, or factors of production, increase as well. So with demand for leather, rubber, and other synthetic materials increasing, the need for more labor and capital(both human and technological), not to mention research and development, to extract and utilize these materials to make these shoes means that wages and jobs will increase in those industries, as will profits. Rickards fails to understand this important positive externality.

Another point he makes in regard to “high-valued” manufacturing jobs that enable supply chain improvements in labor and capital processes is more nuanced than he realizes. The fact is there are no nations on earth with totally local manufacturing supply chains located strictly within their boundaries. Quite often intermediate products and unfinished goods are transported to other countries where they are completed or worked on further. So Rickards isn’t completely accurate in his assumption that an improvement in the supply chain from domestic manufacturing jobs will automatically create more jobs here in the U.S. In fact, this trend has actually been reversing for the past few decades, but it won’t be discussed at length in this paper. Suffice it to say that economies of scale are becoming less relevant over time and manufacturing as a “cultural icon” or a nationalistic concept is a fading ideal.

The more important problem Rickards mentions is the concept of growth. It’s mentioned numerous times in the book as a staple of prosperity. He praises this concept of economic growth as if it’s a tangible, visible thing. In reality it is difficult, if not impossible, to truly measure the value of the production of the economy, and it’s relation to prices and costs. This point is emphasized by economists Robert Wenzel and Martin Feldstein:

These tasks are virtually impossible, and the problem begins at the beginning—when an army of shoppers go around the country at the government’s behest to sample the prices of different goods and services. Does a restaurant meal with a higher price tag than a year ago reflect a higher cost for buying the same food and service, or does the higher price reflect better food and better service? Or what combination of the two? Or consider the higher price of a day of hospital care. How much of that higher price reflects improved diagnosis and more effective treatment? And what about valuing all the improved electronic forms of communication and entertainment that fill the daily lives of most people?

In short, there is no way to know how much of each measured price increase reflects quality improvements and how much is a pure price increase. Yet the answers that come out of this process are reflected in the CPI and in the government’s measures of real growth. This is why we shouldn’t place much weight on the official measures of real GDP growth. It is relatively easy to add up the total dollars that are spent in the economy—the amount labeled nominal GDP. Calculating the growth of real GDP requires comparing the increase of nominal GDP to the increase in the price level. That is impossibly difficult.

As a writer on monetary economics, Rickards should be more focused on the effects of monetary theory on prices of final goods and costs of inputs, instead of looking at growth as an objective indicator of value.

Recently The Economist has questioned the usefulness of GDP as a measure of well-being, among a diverse array of economists. The usual reasons that GDP is not as useful as is thought by the mainstream is that it counts “goods” as well as “bads” which falls for the broken window fallacy, it omits black and gray markets which make up a considerable part of the production structure (especially with barter), and does not consider leisure as an economic good and thus overemphasizes the importance of work instead of relaxation which is a real measure of wealth. In fact, people work less today than they did before World War II. So Rickards’ obsession with growth as a measure of economic well-being is misleading at best, and only gives a rough estimation of the wealth of a nation over a period of time.

But perhaps the most egregious error of GDP is it inability to account for advancements in technology. 50 years ago the U.S. had much higher growth on average than today, yet the technology we possess has changed our lives and wealth in multiple ways. Obviously, the prices of phones, computers, and other similar technological innovations have generally decreased substantially, despite an otherwise inflationary environment. Not only does this improve the wealth of all individuals, it also reduces the prices of inputs and the time it takes to organize them to create the products which is beneficial to businesses as well. These technologies provide things that are not always tangible such as information, data, education, services, and networks. These are often free as well, like free banking apps or stock trading on an iPhone, which isn’t accounted for in GDP. This does not give an accurate picture of how American lives have improved to such a large degree in the last several decades, due to shorter working hours, increased value productivity, lower prices for life-enhancing information technology, and an increasing network of information and communication. None of these things are tangible and thus are largely ignored by conventional GDP accounting standards.

https://hbr.org/2016/07/gdp-is-a-wildly-flawed-measure-for-the-digital-age

A MIRAGE OF CAPITAL AND VALUE

Rickards then moves on to China specifically and the concept of capital. He first states that Ricardo’s concept of comparative advantage cannot hold in a world of mobile factors. If labor and capital can be transported or moved from one country to another with ease then the principle cannot hold true when these capital movements are due to manipulations of trade.

This rests on several errors common to most financial analysts, and Rickards is no different. The first and most important of these is the concept of capital flight. Capital does not move across boundaries. What is known to economists as fixed capital, such as factories or complex machines, typically stays within a country’s boundaries. It is much too costly to have them deconstructed, shipped, and then assembled abroad for businessmen to consider it profitable to do so. If an investor sells a factory in the U.S. to build a factory in a foreign nation because of cheaper labor costs, the domestic factory still remains and is still owned by someone, and thus is able to produce products which still require labor to do so (at the right price).

Taking this concept even further, capital in the sense of stocks, real estate, money, or funds also never leaves a nation’s boundaries, unless dollars are physically transported to the country that the new investment is located in(this is not what Rickards is talking about however). To be sure, dollars never leave the U.S. banking system since the majority of our international monetary system is digital. If one wants to purchase an investment or a good in a foreign country, they must acquire that nation’s foreign currency by exchanging dollars to purchase it whether it is real estate or stocks. But those dollars that are being exchanged never leave the American banking system or U.S. borders. A foreigner who is acquiring the dollars keeps them in our banking system, as the American keeps the foreign currency in that nation’s banking system. As there is a sale of digital dollars, there is also a purchase of digital dollars on the other side. This is why importers and exporters in the U.S. usually have foreign bank accounts of the countries they do business with. This is due to legal tender laws which heavily discourage the use of non-domestic currencies in a country’s boundaries. It is also a good way to diversify against currency risk.

In addition, the same concept applies to stocks and real estate. When an investor flees one stock in favor of another, that stock must be sold by the investor, which implies that there must be a buyer. The value and owner of the stock changes, but it is still owned nonetheless. So if a U.S. citizen chooses to liquidate a stock from a U.S. company, and purchases a stock on a foreign exchange, he must first find a buyer for his stock (who may be a foreigner), and then buy that stock with either his dollars or that foreign currency. If the purchase is made with dollars, then the seller of the stock must hold those dollars in a U.S. bank account. While this bank may be physically located within that foreign country, it is subject to U.S. laws. The capital itself, i.e. money, is not mobile as Rickards states. What’s mobile is ownership, and prices are flexible. They are in constant flux, but the capital stays in the U.S., where it is able to be invested at any time in the local economy. He misses this important nuance. This is true for investing in foreign businesses as well.

His other error is in looking at China specifically. He first states that China has cheap labor costs, but then goes on to say that it is due to this labor being more efficient than U.S. labor. This flies in the face of common economic theory. With higher labor productivity, labor costs like wages and benefits tend to rise proportionately. The reason for this higher productivity can be attributed to more and better capital, better education, better training, and a more stable legal system protecting property rights. U.S. workers are more productive, thus they can demand higher wages than Chinese workers(and they have better options). And it’s true that this can make it more difficult for U.S. manufacturers and exporters, but the source of the discrepancy is not what Rickards thinks it is.

Earlier it was said that the loss of comparative advantage and manufacturing jobs to countries like China were not due to trade manipulation, but automation and the fact that manufacturing has historically been a smaller portion of the whole U.S. economy relative to the service sector in value terms. But even the assertion that China has a large effect on our economy in terms of employment and prices is faulty.

According to economists Jay H. Bryson and Erik Nelson, the U.S. is not very dependent on China’s economy, especially its export markets. Only 7 percent of U.S. exports are sold to China, and that is less than 1 percent of GDP. This means that even under the commonly held belief that the devaluation of the Chinese currency, the Yuan, will reduce prices of their exports as well as make U.S. exports less competitive, this will not result in major job losses or significantly lower growth that Rickards so passionately asserts. On the contrary, the depreciation of the Yuan improves the purchasing power of U.S. citizens in terms of Chinese imports and has little correlation with U.S. consumer prices. As Bryson and Nelson state:

The devaluation of the renminbi should exert some
further downward pressure on Chinese import prices in coming months. Given the high
correlation between year-over-year changes in Chinese import prices and total import prices in recent years, a drop in the former should lead to some further decline in the latter. However, the correlation between import price inflation and core CPI inflation is rather low. Services account for 62 percent of the consumer price index, and the United States imports relatively few services from the rest of the world, let alone from China. In other words, yuan devaluation should have little overall effect on U.S. CPI inflation.

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This non-issue with the Chinese devaluation is further emphasized by economist Steve Hanke from Johns Hopkins University:

The facts are that Chinese exports have steadily risen since 1995, but
they have not been powered by a depreciating yuan. In fact, the
yuan has slightly appreciated in both nominal and real terms. The
accompanying chart tells that story. So, what was said about the
yuan during the [presidential] debate is untrue. But, that yuan story is not a debate
slip. It is disinformation spread by unions, mercantilist of all stripes, and politicians.

Rickards42

One could add Rickards to this list. Again, his intentions are not being questioned here; just his analysis. His book has a tendency to claim foreign protectionism as a source of domestic stagnation, yet finds examples of how protectionism can and has helped the U.S. economy. One of his solutions for slow growth and low-value jobs is to implement:

…an immediate 30 percent import duty on all goods from all sources. This could be made revenue neutral by pairing the tariff with a 10 percent cut in payroll taxes.

The expected outcome is that Apple would relocate good jobs to the United States, where it could reap the combined benefits of lower tariffs and lower payroll taxes. The impact of this policy goes beyond Apple and iPhones to include all high-value-added imports.

One could point to several problems with issuing tariffs to protect domestic industry, but there is one major error that Rickards misses completely that is imperative to his main concern about jobs and growth. To start, when a sufficiently high tariff is enacted in the U.S., foreign exporters are unable to sell to most U.S. importers and consumers due to higher prices. Rickards would agree with this point, but here is where he stumbles in his reasoning.

U.S. imports are bought with dollars. If foreigners are prevented from selling to U.S. consumers because a 30 percent tariff on all imports is made as Rickards suggests, then consumers will buy less of their exports. But if this is the case, then these foreign exporters will not acquire as many dollars for their sale of goods to the U.S. With less dollars, and thus purchasing power, to spend on U.S. exports, decreasing foreign demand will shrink our industrial and manufacturing sector. If this is the case, profits in these industries will be reduced, thus forcing export companies to cut costs causing layoffs and/or a reduction of wages and benefits for its higher-valued employees.

Again, Rickards misunderstands this point about digital capital. A foreigner needs dollars to purchase U.S. goods, and if exporters cannot acquire as many dollars from sales to the U.S., then they will be unable to effectively demand our goods and services in return. This will create more unemployment and reduce economic growth, the opposite of what Rickards claims. He might respond by saying that foreign exporters(as well as citizens) can simply exchange their saved currency, such as Yuan, for dollars if they truly want to purchase U.S. products. Unfortunately, this increased demand for dollars would raise its exchange value in terms of Yuan, making foreign exports cheaper and imports more expensive in terms of dollars relative to that foreign currency. This would be conceptually the same result as a foreign country devaluing its currency.

It should be noteworthy that Rickards disagrees with the notion of protectionism against the United States on the one hand, and proposes the same type of policy against foreigners on the other. He asks advocates of comparative advantage this question: “If U.S. workers cannot get better jobs, and are hobbled by high debts, who will buy what global companies make?” Considering the previous paragraph, the inverse question should be asked to Rickards: If foreign companies cannot get dollars for selling items that now are subject to U.S. tariffs, how will they buy what U.S. companies make?

CONCLUSION

What has been discovered overall is that Rickards, despite his seeming dedication to economic history and monetary theory, has created a mare’s nest of distortion that dovetails with neither theory nor history. He inadvertently follows in the footsteps of other pseudo-connoisseurs of macroeconomics. Unfortunately, the layman can be easily swayed by a lack of context, which is exactly why this paper was written; to give context to these intricate yet accessible concepts. Rickards’ book The Road to Ruin does contain some useful analysis of monetary policy, central banking, and political economy. But when it comes to free trade and some basic laws of economics, he fails to weave a holistic view of voluntary trade that would allow him to see the forest through the trees. The free market, which he pays lip service to, is like that forest. It’s a seeming confusion of complexities that can be thought of as a living organism or even a person, and therefore must be analyzed and treated with rigorous care. And while his diagnosis of catallactic causality could be thought of as a clinical error, Rickards’ main prescription is nothing short of economic malpractice.

NOTE: If you cannot access the link from the Wall Street Journal, here is a seperate link: http://neoliberalism-nightly.tumblr.com/post/79346673329/donald-boudreaux-and-liya-palagashvili-the-myth

Creative Disruption

With the 2016 Presidential Election almost upon us, it has become apparent that this election is taking place at a very important time in our nation’s history. Let me be clear. I am not saying that this election is the most important one we have experienced as a country, nor am I claiming that every single person should look to the voting booth as a means to a stable and prosperous society. On the contrary, it is quite often people find that using political means to achieve any ethical or economic ends is not the most fruitful path. Neither do they find that simply withdrawing consent to be governed a viable option, for the very reason that democracy is a political structure that vies for power and influence. And without a voice, or a vote to commit, one can have neither.

The entire system is a false dichotomy, and that’s not even mentioning this fake narrative that Republicans and Democrats actually have any real differences. The false choice is actually between voting and not voting. Neither choice by itself is a realistic option for change. To make any real difference in the world, an individual must look to what isn’t being said or done at the moment, and carve a path for themselves, while at the same time making this path bear fruit for those who wish to travel a similar one themselves. This brings us to our current predicament.

It is obvious that the people most affected by our political and economic problems are young people, primarily 30 and younger like myself. Millennials are the beneficiaries of the innovations, technology, production, and education provided by previous generations. But for the last several years, particularly since the Great Recession, our future has been thrust into a state of foggy, perpetual uncertainty. To understand why things may seem to be changing for the worse, we must understand how they could ever change for the better.

Bear with me on this. Like any obstacle you have to climb, it can be a challenge. You could think of our social and economic strife as a giant redwood tree, each branch being a smaller issue but as you get higher the branches thicken and block your path. These are the major problems we face as a society. If we are ever going to have a great future, we have to reach the top of that tree. It may be a long, tumultuous climb, but when you get there, your efforts will bear fruit. On your way to helping yourself to that fruit, you’ll be able to provide some for those near the lower branches that are less fortunate than you. This will help solve many of our issues that politics cannot. It starts on an individual level. But first, it is of the utmost importance that you and I fully grasp the simple distinction between politics and economics.

EQUALITY & EQUILIBRIUM

For all of our prosperity, we do not live in paradise. There is suffering, poverty, and a shortage of many of our wants and desires. This is the nature of economics. If it wasn’t, we would have an abundance of everything and would be in a perpetual state of equilibrium where there would be no economic hardships for anyone. While there are several definitions of economic equilibrium, the definition most useful to millennials in our current economy is where the subjective plans of each of us coordinates perfectly with the plans of every other person so that each person can acquire the things that they find most desirable, while at the same time they can provide something that is most useful to one or more individuals. In other words, it is a situation where everybody who wants something is able and willing to acquire it (for a given price). Therefore, there is no economic poverty and no unsatisfied wants in this state of equilibrium.

It is a state of constant bliss, where our subjective preferences are satisfied. Everyone you know has the latest iPhone and internet access. You and your friends all have the money to take a trip to the beach for the weekend. Your parents have the necessary amount of money saved in order to retire comfortably, while you also have enough income to pay off your student loans.

Unfortunately, this state of equilibrium is an impossible concept. It is a unicorn. There are two reasons for this. First, our system of market exchange is a process, not a “state” of being. Every day, people exchange different goods and services for different amounts of money, and work different jobs for different amounts of income. And this is constantly changing. Consumers change their demands, and producers and retailers change the supply of their products based on their perception of these changing demands. Workers change jobs and acquire higher level positions to secure more benefits and income, and people exchange ideas and thoughts to further their own knowledge for their careers. If our economy was ever in equilibrium, everybody would possess everything they need and want, and therefore there would be no room for change or action.

KNOWLEDGE IS POWER

More importantly, our knowledge is constantly changing. By knowledge, I do not mean scientific or analytical knowledge, nor do I mean any kind of technical knowledge. I mean to say that there is a more practical knowledge of the available resources in society. F.A. Hayek calls this “knowledge of the particular circumstances of time and place.” That statement reflects the difference between these two types. The more scientific or technical type is often used by bureaucrats and political planners who often make decisions of how to organize society using methods that only they and other elites possess. The second type is a more widely disbursed and decentralized form of knowledge. In other words, it is a type of knowledge that many people have with regard to their specific location(county, town, neighborhood, etc.) and time frame. They have a tendency to know and anticipate what their local economy demands and supplies better than someone in another location, such as another state or country. This equips these locals, including you, with the “correct” type of knowledge to know what the market demands at any given time. In addition, as time passes the type and scope of knowledge changes with it due to the ever changing availability of resources, demands, and incomes of other locals.

While those with political power can arrange resources to provide public goods on a much more national scale with their access to technical knowledge, these elites do not possess this decentralized knowledge, nor can they conceptualize the idea that this knowledge must constantly change and adjust to serve the needs and wants of specific neighborhoods, towns, and counties. On the other hand, those who possess this widely disbursed understanding of time and place are at a distinct advantage when taking into consideration the idea that they can acquire and sell these resources in a timely, efficient, and cost effective way.

However, this knowledge is virtually never correct or perfect. Desires and wants are completely subjective, and as each second of time passes, they change, sometimes radically. In as little as a month, a new fad may come and fizzle out like Pokemon Go, or a new product may become scarce due to a constantly growing demand outpacing the available supply of it. In a sense, we could call this radical uncertainty. It is the nature of our economy. We have especially seen this since the Great Recession. Millennials in particular have been affected by this.

WE ARE THE MARKET

In 2016 there has been a rise in more interactive forms of exchange. With payment systems like Venmo, transportation services like Lyft and Uber, free investing apps like Robinhood, and new cryptocurrencies like Bitcoin, the U.S. economy and job market has shifted significantly, emphasizing more peer-to-peer interactions.

It is not surprising that the majority of the activity in this new “sharing economy” is comprised mostly of millennials who are younger than 35. While the unemployment rate may be low, over 40 percent of the unemployed are millennials. That is over 4.6 million young people who are out of work. Many of us have student loan debt, which hampers our ability to buy a house, a car, and other expenses we would otherwise be capable of affording. Combining this debt burden with the rise in the cost of living for important purchases has caused many young people to look for political answers.

My purpose here is to convince you, as someone with youth and passion on their side, that you can be the source of actual, real change on a local level. It is not my purpose here to make a moral or ethical case for best way to correct our social problems such as racism and sexism. That is the role of activism. It is to show how, with the right kind of “alertness” to our ever-changing economy, you can change your own troubling circumstances like student loan debt by providing very important needs of others around you. Not through political or activist means; but by the market.

As I stated before, knowledge and information are not perfect and are actually quite limited. We know this. It’s what creates uncertainty. And because of this, our economy is saturated with opportunities. Opportunities that can be created through awareness and alertness. Quite often they are overlooked by the average person. This obvious point was missed by an economist many decades ago named Lionel Robbins. He was a sensational theorist who correctly diagnosed the causes of and solution to the Great Depression. One of his lesser contributions was stated in the idea that market actors, like you and I, are simply “economizers”. What this means is that we pursue what we think is our desire at a given moment, whether it be a day at the spa or a lunch at a nice restaurant, with readily available information that we know with certainty is correct. In other words, that the goals and the means to achieve these goals for us are knowable and given.

He was wrong. Again, this is chasing a unicorn. It doesn’t exist. We often don’t know the correct way to achieve our goals, or at least don’t necessarily know the least costly way. In order to achieve our goals, it is necessary to know what our choices are. These are called opportunity costs. It’s not a monetary cost, per se, but a subjective cost that we internally weigh against other choices or paths we could choose instead. It just so happens that costs are usually calculated in terms of dollars.

PRICES ARE KNOWLEDGE

The most important aspect of this idea is the concept of a price. A price is simply a way of determining how much of something is to be exchanged for something else. It’s a ratio, nothing more. It’s almost always calculated in terms of money, just as costs are. Economic theory isn’t important here, but what is important is the idea that prices contain information. Or to be exact, they contain imperfect information. An economist from St. Lawrence University correctly calls them “knowledge surrogates”, due to this lack of perfection. They convey information that tells you how much money it will take to acquire something you want.

The crucial point is here is that these prices are almost always wrong. This is because this is not Nirvana. Retailers and store owners don’t know the exact price that should be charged to gain them the biggest profits, and this implies that the price they charged for any product is either to high or too low. If the price is too high, less of it will be demanded, and there will be too many of these products left on the shelves. This means there will be unsatisfied customers who didn’t get what they wanted at a low enough price, and must settle for the next best thing. If the price is too low, there will be an overabundance of demand for it, and therefore there won’t be enough of the product to satisfy every customer. This means that some of them will go unsatisfied as well.

YOU ARE THE MARKET

This is where you come in. You may not be aware of it, but you’re an entrepreneur. Even now as you are reading this, you’re profiting. You may be thinking this is wrong, but remember what I stated earlier. Prices and costs are inherently subjective. You value your wants based on the alternative choices you have at a given time. Even though they can be calculated in terms of money, they are based on our personal desires and wants. In a state of equilibrium, prices of these things would equal costs, and there would be no need for action. So the fact that you have decided to read this instead of watching TV or playing Candy Crush on your smartphone shows that you have considered all of the alternatives you could have chosen, and have decided that this is the most profitable choice, based on these opportunity costs.

In this regard, everyone is an entrepreneur. Yet there is more. While bankers and rich capitalists seem to have more than enough means to acquire their wealth, you are in a similar situation, but for a different reason. While someone in the top 1% of income earners has more wealth than you, he requires capital to acquire it and maintain it. This capital does not simply mean money. Usually the wealthy obtain “income streams” from capital such as real estate, factories, patents, stocks, bonds, derivatives, and other financial instruments. These income streams are perpetually propped up by our monetary system, which typically benefits the wealthy through the manipulation of money and interest rates. While it’s extremely unfair to younger people to have to watch their incomes and job opportunities stagnate or fall, it’s a harsh reality.

There is good news, however. You don’t need real capital to make money or to start a small business. The only thing that is requires of you is alertness to opportunities. You could call this discovery; discovery of a good or service that is undervalued in one part of the market and overvalued in another. This good or service could be anything. It could be tangible like a toy for special needs children, or a service like providing cheap tutoring online. A important aspect of this alertness is the fact that these products are able to be acquired at a cheaper price in one area and sold at a higher price in another. This is known as arbitrage.

This may seem like it’s too good to be true, but it’s not. There are nuances of course, but if the difference between these two prices is large enough to enable you to offer an interest payment attractive enough to compensate a friend, family member, credit union, or investor into lending them the money to purchase the cheaper good in order to sell it for a profit, then you are not required to “own” the means or capital in order to create value in the economy. So you and I as college students or workers don’t need to necessarily scrape up every dollar we can to take advantage of the general ignorance of these possible opportunities. Although, many of us probably have sufficient savings to pursue at least a few of these price discrepancies. There are many other scenarios where this purely entrepreneurial function can work for us too.

PURE ENTREPRENEURSHIP

What separates this concept from the money and wealth that capitalists and investors make is what has been called pure profit. As an investor or businessman, there is inherent risk to each productive endeavor taken. Should they fail, they will effectively lose their capital, i.e. their income streams. We can infer from this that there are costs incurred in order to make their products they want to sell for a profit. Any revenue they receive from customers that is in excess of these costs, such as labor or tools, they then retain that money as profit.

Yet this is not the same as pure profit. This is a concept stated by economist Israel Kirzner which is based on the idea that an alertness to these previously unrealized opportunities enables a person to take advantage of a virtually riskless endeavor to buy resources at a lower price and sell them where they are more valuable to society. The main difference of these two types of profit is that pure profit can be obtained with no capital and a minuscule amount of risk or none at all! While you can never completely eliminate uncertainty, you can minimize it to a negligible amount, or ignore it completely. Robert Wenzel from EconomicPolicyJournal.com puts it best:

 

If a man spots a ten dollar bill on the sidewalk on a calm windless day, is he in our world in any real sense uncertain that if he stoops down to pick it up there is a risk that he won’t get it?

Yes, a meteor may fall from the sky that very moment and as he turns his head down, it could knock him dead. A truck could jump the curb and knock him dead. A swarm of bees could find him and sting him as he stoops. All these are indeed possibilities…

the man most assuredly is not going to enter into his calculations that a meteor, truck or a swarm of bees will hit him just as he stoops for the ten dollar bill. In actuality, this was a riskless transaction, taken in the context that we must act within the realm of many minute uncertainties and much impreciseness.

 

This may seem like a exaggeration, but it’s absolutely true. With hardly any starting capital and with virtually negligible risk, you can provide real value and thus change to both your and others’ well being. All that is required is two things. The first is discovering where a product, service, or good is under priced, and where in your economy it is overpriced. This will open up a previous unknown chance to create value. Second, you need to discover where buyers have been paying too much and sellers receiving too little and to narrow that margin by purchasing the good for a little more and selling it for a little less. This would benefit buyers with a lower price, sellers with a higher price, and you with a pure profit. Closing this gap will bring the economy closer to equilibrium, and thus make people, including you, better off. It all comes down to alertness. Data and prices alone cannot do the job, it takes a certain amount of subjectivity and perception. Perhaps it can even be on a subconscious or accidental level. Fear is surprisingly also a fairly common motivation for entrepreneurs. It gives them a reason to be more detail-oriented and cautious of their environment.

REAL WORLD EXAMPLES

One brilliant example of this pure entrepreneur could be seen in Britain recently. A teenager named Beau Jessup discovered in a visit to China that Chinese parents were naming their newborn children embarrassing names such as Rolex and Cinderella. Her parents’ friends there also asked her for name ideas for their children. She decided to create a website called Specialname to assist these parents in naming their children with more culturally appropriate names that fits the family’s tradition and values. Beau’s alertness to this opportunity has lead to over 200,000 babies getting names from her only 6 months after the website began. She has made $86,000 dollars since then. It’s interesting what she stated about the whole endeavor:

 

“I wanted to do it just to see if an idea could turn into more than just simply an idea. And I never expected it to become more than just a small project. It is obviously a nice surprise, but it is definitely a surprise.”

 

So you can see that it doesn’t take a purposeful attempt to find these possibilities and opportunities. As I said, it could be just curiosity or purely coincidence, as was the case with Beau. She took on virtually no risk and owned no capital. All she needed to do was to create a website, and these days that can be done with little or no cost. In addition she will be using the pure profit from the website to pay for her education. And on top of that, her costs were most likely negligible, as prices for internet access can vary between $1 an $5 per day, but some entities such as NetZero and Earthlink charge less than $0.45 for dial up. Access to the internet is extremely cheap for most people in developed countries, especially in the U.S. Here are several examples of this inspiring pure entrepreneurship:

 

http://schumpeterscentury.blogspot.com/2010/08/kirzners-arbitrage-entrepreneurship.html

http://www.economicpolicyjournal.com/2013/01/kirznerian-entrepreneurship-at-edge.html

http://www.nzherald.co.nz/world/news/article.cfm?c_id=2&objectid=11705726

 

CONCLUSION

These people show not only alertness to the needs of others, but also the desire necessary to change the world around them. They in turn have benefited as well. That is the way of markets. To create value means to receive value, not the other way around. So instead of spending all of our time arguing for more ambiguous social programs, advocating for abstract “rights”, and verbally attacking others that have a different vision of a moral and prosperous society than us, let’s try something different other than going along with the herd.

I believe in democracy. Not democracy in and of itself, but the democracy of the market. The idea is that we all have a say in what others create. Not by our votes, but with our wallets. Most people don’t see this, but it’s reality. If you can create this wealth on a local level, then you can reduce uncertainty for others. You can provide more value and better choices than what’s out there. Like you, I know that finding a comfortable job with benefits and a pension is becoming more difficult to find, especially for the young. That is because our economy is changing. How this change occurs depends on you. This isn’t some dry, idiosyncratic concept meant only for intellectuals. This is a real world explanation for what you are capable of as an individual. You can be an agent for real change, a pure entrepreneur. All you have to do is be alert to opportunity.

 

NOTE: Here is an example of someone who used morality as more of a motivation for entrepreneurial discovery than profit, and yet he used the means of the market to do it:

The “Miracle” of Kirznerian Entrepreneurship

 

CAN YOU PROFIT BY SAVING? AN EXTREME MONEY OVERTURE

 

As the world economy heads further into uncharted territory with commodity deflation, negative interest rates abroad, The Brexit, and the economic turmoil in Venezuela, one notable economist and former U.S. Treasury Secretary, Larry Summers, has proposed a radical solution to curb criminal activity, drug and human trafficking, tax evasion, and money laundering by eliminating large denominational notes in both the U.S and Europe through either legal tender laws or by legislation. His proposal is based off of a working paper by Peter Sands from the Mossavar Rahmani Center for Business and Government.

This policy would include the 500 Euro note and the $100 bill. By 2018 , the European Central Bank will no longer be producing the 500 Euro(although it will still be considered legal tender) and it will be slowly phased out. At first glance, this may seem like a harmless policy change. After all, as Summers states, “There is little if any legitimate use for €500 notes. Carrying out a transaction with 20 €50 notes hardly seems burdensome — and this would represent more than $1,000 in purchasing power.”

Kenneth Rogoff, the Thomas D. Cabot Professor of Public Policy at Harvard University and former chief economist of the International Monetary Fund, has echoed Summers in a recent essay for the Wall Street Journal. His claim is that the use of cash in general not only gives rise to the same criminal activity that Summers has stated, but also enables illegal immigration by allowing these workers to be paid off the books in cash. The difference between Summers and Rogoff is a matter of degree, in which Summers only targets eliminating the $100 bill, while Rogoff suggests that the $20 bill and $50 bill are be phased out as well.

To be fair, phasing out the largest of these denominational bills would prevent virtually no day-to-day transactions, for the lone reason that this note is the equivalent of a $600 bill. However, in this article, I will discuss why I believe that this potential future policy (particularly in the U.S.) creates a unique opportunity for investors,savers, and businesses.

An important addition to this policy that is mentioned by Rogoff is that interest rates must go into negative territory in order to stimulate spending and borrowing so that the increased economic activity will induce businesses and investors to spend and invest to combat the low economic growth the U.S. has seen in recent years. In what economists call the zero lower bound, where effective interest rates go below zero, businesses should theoretically be induced to borrow with such low borrowing costs, and consumers should be more willing to spend instead of save due to such low rates. As Rogoff states:

In principle, cutting interest rates below zero ought to stimulate consumption and investment in the same way as normal monetary policy, by encouraging borrowing. Unfortunately, the existence of cash gums up the works. If you are a saver, you will simply withdraw your funds, turning them into cash, rather than watch them shrink too rapidly. Enormous sums might be withdrawn to avoid these loses, which could make it difficult for banks to make loans—thus defeating the whole purpose of the policy.

Take cash away, however, or make the cost of hoarding high enough, and central banks would be free to drive rates as deep into negative territory as they needed in a severe recession. People could still hoard small bills, but the costs would likely be prohibitive for any realistic negative interest rate. If necessary, central banks could also slap temporary fees on any large withdrawals and deposits of paper currency.

My analysis will be limited to the $100 bill in particular, although if smaller denominations are eliminated afterward then this will also apply to them to a lesser extent due to the higher rates of inflation that are likely to follow such policies including negative interest rates charged on checking deposits and savings accounts. While real interest rates in the U.S. are currently negative due to price inflation exceeding the rates that banks are paying to customers, I will be focusing on negative nominal rates from this point on(unless otherwise stated). I will also ignore the moral and ethical arguments against this policy which have been stated already.

According to recent estimates by the Federal Reserve, the total amount of money in the U.S. economy(known as M2) is currently about $12.7 trillion. However, most of this money is digital, with only $1.4 trillion, or 11 percent, consisting of physical cash(approximately half of which is held abroad). The rest is contained digitally in checking and savings accounts among others. Of this $1.4 trillion, $1.08 trillion are composed of $100 bills. So over 78% of all the value of physical currency in circulation is from these large notes.

coin_currcircvalue

Assuming that negative interest rates will be combined with both the halt in production of such large denominational notes and the elimination of their legal tender status(or them being outright outlawed), it can be safely assumed that there will be one of two outcomes. Either 1) $100 bills will be hoarded or 2) they will still exchange and circulate at a “premium” to digital dollars. For it to be determined which of these is the likely outcome, it is necessary to understand a concept known as Gresham’s Law.

 

A VARIATION OF GRESHAM’S LAW

In its most basic form, Gresham’s Law states that “bad money drives out good money”. But this is not complete. For this to theoretically hold true, the exchange rate between the “good” money and the “bad” money must be equal. Or to be even more precise, the legal exchange rate at which these two monies exchange must differ from the market(non-par) price. In that case, debts and transactions will be paid with the bad(overvalued) money, while the good(undervalued money) will be hoarded.

A Federal Reserve research paper by Rolnick and Weber questions the theoretical and historical validity of Gresham’s Law, providing substantial evidence that undervalued money doesn’t always disappear from circulation. They found several examples in the U.S. of undervalued money (alternating between gold and silver at different periods) actually circulating at a premium beside the overvalued money dictated as legal tender by the federal government. For example, between 1793 and 1846, when gold was undervalued at the mint(1793-1833), 25% of the money in circulation consisted of gold; when silver was undervalued at the mint(1834-1846), almost half of the money in circulation was silver. They make this observation, as well as others, and base it on the existence of fixed transaction costs, rather than fixed exchange rates(between these monies) which, according to their research, have never actually existed:

If such a rate were ever managed-through a mint policy or a legal tender law, for example-it would imply potentially unbound profits for currency traders at the expense of a very ephemeral mint or a very naive public.

It is my contention that a similar version of Gresham’s Law will apply with the abolishment of cash, particularly higher denominational bills previously mentioned, being combined with negative nominal interest rates. There are several differences between my version and the one proposed by Rolnick and Weber. While their work is based almost entirely on gold and silver as monies at different time periods, I will be concentrating on physical cash versus digital dollars. But before it can be seen why real dollars will circulate with digital dollars at a premium instead of being hoarded, it must be understood why the idea of a significant general price deflation, or a rise in the purchasing power of the dollar(whether digital or real) in the U.S. economy, is extremely improbable without negative interest rates and legal tender laws.

 

DEFLATION AND INFLATION

First, while the banking system, operationally known as fractional reserve banking, allows for both an expansion and contraction of the money supply, the incentives for an expansionary monetary policy greatly outweigh the latter. This is in spite to the fact that deflation, while good for creditors(i.e. banks), is bad for debtors(individuals). However, if deflation is significant this relationship only holds true up until the moment of default on the part of the debtors, who cannot repay the loans to the creditors due to the increasing nominal value of debt. Default is the instantaneous transfer of wealth from the creditor to the debtor. If this were to happen on a large enough scale, the banking system would be heavily crippled. It can also be ascertained that while the government can gather revenue from taxes on capital gains and especially rising nominal incomes, the same cannot be said in a deflationary world. With the prices of goods and services falling, real incomes and wealth are increased, even though nominal incomes stay the same or fall less than prices. The difference is, the government has yet to figure out a way to tax the increase in real wealth with deflation. They can only do so with inflation and the inevitable rise in nominal wages that accompanies it. And in a serious deflationary recession the federal government will be hard-pressed to collect tax revenue if GDP falls, unemployment rises, and the banking system falters. It should be said that it is conceptually possible for the government to do this in a similar manner to which they do it with rising nominal incomes. The problem would be using a price index that is accurate in estimating falling prices. While it is possible, it can be ignored for the purpose of this analysis.

Second, due to the digitalization of monetary exchanges in our economy, consumers are becoming less inclined to carry physical cash around with them. This is primarily due to the existence of credit cards, debit cards, and EBT cards. These “substitutes” for cash, along with other clearing systems, have reduced the demand to hold cash balances, thus artificially raising relative prices more than what they otherwise would have been over time(when coupled with low rates). Other digital payment systems such as Paypal and Venmo link directly to your bank account, reducing the need to exchange real dollars. This also reduces the demand to hold physical cash(balances).

Third, and most importantly, due to the nature of fractional reserve banking, a significant fall in prices in our economy rests solely on money being “idle”, or not spent. In other words, if, generally speaking, cash balances are lower than they otherwise would be due to the previous reasons given, then the possibility for deflation is virtually eliminated. The last time the U.S had any real deflationary pressure was during the first years of the Great Depression. This is primarily due to consumers taking money out of their respective banks and “hoarding” it. While this is certainly possible for consumers to do today, it cannot be maintained in the aggregate. As economist Gary North states:

…it is not possible for depositors to take sufficient money in paper currency notes out of banks and keep these notes out, thereby reversing the fractional reserve process, thereby deflating the money supply. That was what happened in the USA from 1930 to 1933. If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is FED policy to decrease prices. This was not true, 1930 to 1933.

Consumers, while currently having the power to hoard physical cash, don’t have the means to prevent this money from being stored digitally while they still use it, to any extent, as a medium of exchange.

 

A CHANGE IN LEGAL TENDER STATUS

Now, let’s explore a scenario where the Federal Reserve lowers nominal interest rates below zero, thus causing banks to do the same to their depositors(to maintain profit margins). This could be due to inflation slowing(disinflation), a significant correction in the stock market, or some international economic disturbance such as Brexit. If the Fed gave markets significant notice of this policy change, consumers would merely begin to withdraw their money from banks and acquire cash to escape the negative rates, which is essentially the same as saying that they would be paying the banks to hold onto their money. But what if the government changed the law so that large notes over $50 were no longer considered legal tender(coupled with the the U.S. Treasury no longer printing $100 bills) or were made illegal as money as proposed by Summers? While the outcome would be similar if not the same for either policy, we will look at both separately.

Let’s take the circumstance of a change in the legal tender status of the $100 bill first. Most would respond that those still possessing $100 bills would simply hoard them, transforming them from a medium of exchange to an asset to be held as a buffer against uncertainty or inflation, as they(and gold were) during the Great Depression. This, however, would most likely not be the case. Legal Tender laws are often confused with the idea that only legal tender can be used in both private and business transactions. But this is not true. From the Federal Reserve’s official website:

Section 31 U.S.C. 5103, entitled “Legal tender,” states: “United States coins and currency [including Federal reserve notes and circulating notes of Federal reserve banks and national banks] are legal tender for all debts, public charges, taxes, and dues.”

This statute means that all United States money as identified above is a valid and legal offer of payment for debts when tendered to a creditor. There is, however, no Federal statute mandating that a private business, a person, or an organization must accept currency or coins as payment for goods or services. Private businesses are free to develop their own policies on whether to accept cash unless there is a state law which says otherwise.

In other words, there is no reason why a consumer cannot pay for a product with another type of money other than dollars. This can be seen with the creation of Bitcoin and others “crypto” or purely digital currencies. Websites such as Overstock.com and Expedia, along with many brick-and-mortar businesses accept Bitcoin as the means of final payment for their goods and services. While these payments are most likely eventually exchanged for dollars, this is beside the point. Economist Bob Murphy makes this clear:

Even though the US government can tell Americans which pieces of paper are dollars, it cannot tell Americans that dollars are the money that they will use economically. The existence of legal-tender laws and other regulations complicates the issue, but nonetheless it is possible that next Tuesday, nobody will want to hold US dollars anymore and so their purchasing power will collapse, with prices quoted in US dollars skyrocketing upward without limit. This has happened with various fiat currencies throughout history, and these episodes did not occur because the State in question repealed a regulation that had previously ensured its currency would be the money of the region. Instead, the people using that currency simply abandoned it in spite of the government’s desires, resorting either to barter or adopting an alternative money.

In a world of negative interest rates, consumers would be induced to withdraw their money from banks due to the opportunity cost of paying a “fee” for having the banks holding their deposits. In essence, if the $100 bill were no longer legal tender according to law, these large notes would still be used as a medium of exchange. This is especially true if price inflation is increasing which is a likely scenario in a negative rate environment, which would cause digital money to be exchanged at a discount(and physical dollars including the $100 bill at a premium).

In addition to negative nominal interest rates charging a percentage to customers’ digital accounts, there would likely be an increase in bank fees. These would include, but not be limited to, debit card fees, overdraft fees, user fees, and ATM fees(for withdrawing small bills), not to mention hidden fees. For example, according the Wall Street Journal, out-of-network ATM fees have risen over 50% in just the last ten years. While these fees already exist, there is considerable reason to believe they would be expanded or increased as such due to the fact that the majority of U.S. citizens would be discouraged from using larger denominational notes, and hence would do a larger percentage of their transactions with real money. While taxes on wages cannot be avoided due to the infamous withholding tax, a policy that eliminates $100 bills as legal tender would only further encourage holders of real dollars to use them in exchange. This is because all official purchases with digital money would be more easily tracked than if they were used with tangible money. This would make it easier for the state and local governments to levy bigger consumption taxes on all purchases of goods and services. In fact, in September 2012, the government of Argentina introduced a 15 percent tax surcharge for every time a purchase was made outside the country using a credit card issued by an Argentine bank. In addition, taxes on investments will encompass more of the economy. While today most investments are made electronically such as bonds, stocks, and real estate(most of which incur capital gains taxes upon liquidation), there are still investments that are made “off the books” and thus are not subject to taxes. This would most likely expand(along with similar consumer purchases) if such a policy were implemented, but with holders of real dollars possessing the advantage over non-holders.

 

THE ABOLISHMENT OF $100 BILLS

Now let’s introduce a law that completely eliminates the use (economically) and production of $100 bills(during a period of negative interest rates). This is the extreme version of the proposal of Summers, Rogoff, and a few others. At first glance, it would seem unlikely that anyone would be willing to use or exchange something that has been completely outlawed by the government. However, there are numerous examples throughout U.S. history that have shown this to be false including prohibition and the “War on Drugs”. Assuming a large enough percentage of consumers will either ignore or purposefully disobey this new law, a case can be made that the holders of these $100 bills at the time of it being implemented will see windfall gains.

Under our assumptions thus far it seems that there will be a meaningful amount of consumers and market participants who not only foresee the ability to gain from these extreme policies, but they’ll also be willing and able, to a large extent, to avoid these laws due to the amount of anonymity that comes with using real cash (more on that later). This will solve the problem of network effects. Network effects exist when the desirability of an object or objects is dependent on the amount of people using it in a given area. The result will be a catallactic nexus of market participants, composed of wage earners and entrepreneurs, who interpret this transitory period as an opportunity to obtain premiums on exchanging their holdings of the now illegal $100 bills for goods and services from others who also use and accept these bills. This will occur instead of consumers merely hoarding these larger bills for several reasons.

With the cessation of the production of $100 bills, a law prohibiting the use and exchange of said currency would allow for an increase of the value of each note relative to the total physical supply(with a given demand). This stabilization of the supply of large notes would cause a significant price deflation, particularly in relation to the price of the same goods in terms of digital money(and smaller denominational notes). While the supply of $100 bills will most likely remain the same and circulate outside of the “digital” economy, there will be a tendency for the supply to decrease over time for two reasons.

First, physical pieces of paper that are used as money deteriorate over time as they’re handled by a multitude of people in countless situations. It’s only natural that the wear and tear to these large notes will at some point become too severe for them to be accepted at par with newer, fresher looking dollars(or to be accepted at all). And since the treasury is no longer printing these specific dollar bills, the supply will fall. Second, as professor North stated, there will be a tendency, albeit a small one in this case, for users of the $100 bills to either deposit their bill in a bank account themselves, or to initiate an exchange with a market participant who, for whatever reason, may decide it to be advantageous or convenient to hold his money in digital form(perhaps he feels there is less risk of theft of storing money in his bank than in his wallet or under his mattress).

This is in contrast to digital dollars, which will almost certainly see an increase in supply due to the incentives banks have to loan more money out. This is due to the fact that in a negative rate environment, banks that keep their reserves at the Federal Reserve will pay a fee to have them held there, rather than be paid a small percentage on the reserves as has been the case historically. On the other hand, it could be argued that the demand to use digital dollars in exchange could vastly exceed real dollars, especially in a inflationary period. As economist Finbar Feehan-Fitzgerald claims:

A currency experiencing more inflation than substitute currencies would be used in trade as often as possible. This would serve dual purposes. First, the owner of the substandard currency would prefer to use it in trade in order to keep their more stable and more robust currency in hand. Second, an individual in possession of the value-losing currency would rush to exchange it in order to obtain goods losing value less rapidly than the said currency.

Laws and policies aside, we have seen that historically this doesn’t hold true however. Moreover, as Nobel laureate F.A. Hayek states:

Beyond the desire to use his regular receipts for his ordinary
expenditure, the wage- and salary-earner would probably be
interested chiefly in stability. And although in his mortgage
and instalment payments he might for a while profit from a
depreciating currency, his wage or salary contract would
incline his wishes towards an appreciating currency.

As mentioned earlier, deflation tends to favor wage-earners and creditors and inflation tends to favor debtors. During a period of negative interest rates, while digital money is losing value relative to physical dollars(particularly the $100 bill), the opportunity cost of paying off debt using digital money falls relative to real large notes. This means that digital money will be more advantageous to use in paying off debts and fixed installment payments. But consumers and wage-earners will no doubt prefer an appreciating currency to acquire more goods and services with a given amount of labor. While these market participants won’t be able to acquire these appreciating $100 bills(except in exchange with someone willing to part with them) through their banks or paychecks, the owners of $100 bills who possessed them the moment these policies were implemented will see their currencies stabilize and even decrease in supply, and rise in purchasing power relative to digital money, which will increase in supply(due to increase in lending and inflation), and decrease in purchasing power(due to fees and negative rates on bank accounts). Hence, these real dollars will command a premium over digital money, which will inversely exchange at a discount.

Another reason market participants will be encouraged to use physical currency in trade instead of digital currency is the likely price controls enacted by the government due to any significant amount of inflation in the economy, most likely caused, in part, by negative interest rates. As I stated earlier, digital money can easily tracked by the banking system and a nation’s government. Every transaction using a smartphone, credit card, or Paypal can be recorded in a digital ledger that the issuing bank, phone application, or clearing house can keep in it’s database so that the government can have easy access to where people’s money is going. This makes it virtually impossible for anyone to buy products whose prices are fixed by law to acquire said goods at any other price as long as they use digital money. On the other hand, transactions using physical dollars are completely anonymous, and while purchasing goods at below the government-mandated prices would be technically illegal, anyone who would be willing to take advantage of the premiums that real dollars have over digital money would be able to do so in the likely scenario that producers would be participating in the black market.

 

PROFESSIONAL PROPOSALS

Economist Robert Wenzel has suggested in a recent article that in a scenario where ATM withdrawals are restricted for any reason, as little as ten thousand dollars under the bed could possibly equal $100,000 in buying power during such a period and “those who have cash are going to be in a very strong position in terms of buying power.” While he does not go into detail about why this is so, it can be deduced that it is a lack of real dollars that would cause this discrepancy in value. This falls in line directly with our analysis that a lack of supply of real dollars, including other factors, relative to other currencies will raise the purchasing power of the limited currency when measured against the unlimited currency.

A more realistic example has been made by University of Michigan professor of economics Miles Kimball. He proposes that central banks proactively eliminate the exchange rate between electronic money and physical money. Instead of depositing $100 into your bank account and it being credited with an equal amount, you would be credited with $98 for example, which would equate to negative two percent on deposits. This would instantly create a scenario in which physical dollars exchanged at a premium against digital dollars. Simultaneously the government could sever the ties in value between deposits and cash by not requiring banks to accept cash as legal tender. Whether the federal government makes cash illegal or not is immaterial. Anyone who uses cash would be at an advantage. Professor Kimball adds:

“Businesses have got to start planning for this. Any lawyer who writes a debt contract without stipulating what happens if the market price of a paper dollar is not equal to an electronic dollar has to wake up… There’s going to be some central bank that does what I’m suggesting, and the companies who didn’t prepare for it are going to be disadvantaged.”

He makes the claim that what we have stated about individual holders of $100 bills also holds true for businesses as well. While physical currency would be exchanged at a premium, it would be advantageous for them to transact with it. In addition, since both types of currency would be legal to use, any business or corporation could float bonds to raise capital. However, in this negative rate environment, lenders( larger businesses) would pay borrowers(citizens) to borrow money. In his example, he says that the government could make it legal to accept both cash and digital money as payment, which is significantly different from the scenario I’m presenting in my analysis. It seems more than likely that the government will instead outlaw cash entirely so central banks can get past the problem of the zero lower bound. Yet this scenario that Kimball presents as being probable only strengthens my analysis by demonstrating the desire for market participants that are aware of such policies to secure profits rather than incur losses.

We have seen that policies of negative interest rates combined with the elimination of high denominational notes will cause those notes to be exchanged at a premium versus digital money, rather than disappear from circulation as is claimed by proponents of Gresham’s Law. Given that there will be a substantial amount of market participants who anticipate these policies and their effects, they will be at an advantage when their physical notes climb in purchasing power while simultaneously digital money begins losing its purchasing power. To the extent that this holds true, it will be seen that there is an inherent economies of scale in terms of money through reduced transaction costs(fees and taxes) by the limitation of their supply. Those who attempt to withdrawal money from banks to acquire real dollars such as the $100 bill will not be permitted through law to do so. This will create a “grey economy” where those who seek alternatives to digital money will be able to do so through network effects. In addition, there are several recent real world examples that support our position.

 

GRAY ECONOMIES & GRESHAM’S LAW

Since Argentina defaulted on its foreign debt in 2001, it’s currency, the peso, has collapsed in value by over 75%. While the government has tried to raise it’s value on the regulated official exchange rate using its foreign reserves, Argentinians have been attempting to pay large premiums for higher valued currencies such as dollars which are traded on the black market as “blue dollars” at prices far exceeding the official exchange rate. For example, according to The Economist, in late 2015 citizens exchanged pesos on this “blue dollar” rate at a rate of over 14 pesos for one dollar, compared to an official exchange rate just under 10 pesos for one dollar. That is an over 40% premium for a more stable and trusted currency. Even more interesting is the fact that in September 2012, the official exchange rate was 4.63 pesos for one dollar, while unofficial rate was 6.39 pesos for one dollar. In essence, in 2012 dollars held a premium of roughly 27% over pesos, while 3 years later, in 2015, they held a premium of more than 40% over pesos. Thus it is obvious that Gresham’s Law does not hold true regardless of the effective exchange rate maintained by the government. This in fact shows that policies that devalue currencies can have effects that last for years.

In Venezuela, price inflation was over 150% for fiscal year 2015. At the time of this writing it has increased to 500%. It is estimated by the International Monetary Fund that inflation will be over 1600% in the coming year. As of February 2016, there are four different exchange rates used to trade bolivars, the official currency of Venezuela, for dollars. The official exchange is called CENCOEX, in which one dollar can be acquired for 6.3 bolivars. The other two exchanges are SICAD 1 and SICAD 2, which require 12 and 50 bolivars, respectively. The newest exchange is called SIMADI, which requires around 200 bolivars in exchange for one dollar. While each of these 4 exchanges has different uses for different market participants, they all have one thing in common. It is considered to be quite difficult to acquire dollars at these more favorable exchange rates for reasons such as fraud, lack of trust in both the stability of the bolivar and the process of acquiring other currencies, capital controls, transaction costs, and the overall bureaucracy that no doubt inflicts monetary costs to users that wish to make these exchanges at the going rate(s).

As a result, Venezuelans have relied on the black market to acquire foreign currencies like the dollar. While it is possibly easier to acquire dollars at the black market exchange rate, it is much more expensive to do so. For example in early 2016, the black market exchange rate was 900 bolivars for one dollar. This is more than a 400% premium for dollars than the highest official rate. The vast majority of citizens that can acquire dollars at the black market rate are only the wealthy and higher-income earners. And these citizens primarily hoard the cash as a means of saving. Unfortunately in the case of both Venezuela and Argentina, there isn’t much data on the use and hoarding of high denominational dollars in these countries. Peter Sands states:

…it is hard to imagine that Argentina’s persistent mismanagement of monetary policy and banking would have continued so long if the elite did not have the dollar alternative. Through access to US $100 bills, elites secure insulation from domestic monetary and banking disasters, which weakens their incentive to seek change. Whilst there is no data to prove this, we would suspect that in most such countries, access to and holdings of foreign currency high denomination notes is highly concentrated.

So these dollars are seen as more of an asset than a medium of exchange to the wealthy and high-income earners. However, it has been observed by some economists such as professor Steve Hanke of Johns Hopkins University, that citizens of Venezuela have begun abandoning bolivars and started using dollars in trade when he states:

Facing this inflationary theft, Venezuelan’s have voted with their wallets. Indeed, they have unofficially begun to dollarize the economy.

Companies such as American Airlines and Ford Motor Co. have stopped accepting bolivars as payment for their products. This “partial dollarization” seems to be spreading with a lag along with the massive inflation that has decimated the bolivar. In fact, while most real estate contracts are calculated in bolivars, in higher income areas, many owners do business outside the law and accept payments and rents in dollars only.

The difference between the scenario in Argentina and Venezuela, and the one of negative rates in the U.S. is that in those examples, the more stable currency that held a large premium over the inflationary currency was a foreign currency. This implies that once citizens of these countries realized how devastating the devaluation of their currencies would be, it became either too expensive or too difficult for many to import dollars or euros in order to acquire necessary domestic goods and services. Because of this, the ability of a more stable currency, despite its exchange premium over the depreciating currency, to circulate in the black market is significantly hampered by the lack of network effects(though not completely eliminated).

This is in contrast to the U.S. where both real dollars and digital dollars are both domestic. This means that international transaction costs are essentially eliminated and many market participants will already possess the requisite amount of physical dollars to create the network effects necessary for them to take advantage of the premiums their dollars will have in exchange over digital dollars.

LOWER TRANSACTION COSTS 

In a working paper previously mentioned titled, “Making it Harder for the Bad Guys: The Case for Eliminating High Denomination Notes”, Peter Sands makes the argument that high denominational notes such as the $100 bill should be eliminated from circulation. His reasoning isn’t important for the purpose of our analysis but there are several points to be made in relation to our claim that in a negative interest rate environment with the abolishment of cash, it will be advantageous to use physical currency in trade.

According to Sands, cash is the preferred proxy that criminals use whether in high denominational notes such as the $100 bill or in lower denominational notes. The difference, he claims, is that lower denominational notes play an important role in everyday exchange in the economy while higher denominational notes have very little impact. Criminals involved in illegal activity could still very easily conduct illicit activity using $5, $10, or $20 bills, but it would increase transaction costs and transportation costs, particularly with cross-border exchanges. And even with domestic or local transactions, the ability to exchange with anonymity would be more difficult due to the larger amount of smaller denominational notes that would be required to conduct a transaction of the same value in $100 bills. He states:

Criminals are not going to stop being criminals simply because we eliminate high denominations. So they are going to look for other ways to make payments and move and store value surreptiously. The issue is whether the substitutes are more expensive, less convenient and carry greater detection risk. The most obvious substitutes are lower denomination notes of the same currency. Yet using these would raise the cost of doing business for criminals, since they are bulkier and heavier.

Thus it easy to see why in the same paper, Sands finds that $100 bills exchange at a premium with smaller U.S. dollar denominations in many emerging markets.
Cash premiums for Paper

 

This discovery seems to somewhat reflect the analysis of the paper by Rolnick and Weber on a different version of Gresham’s Law. They argue that the determining factor of whether a currency circulates at a premium is based on the costs of paying such premiums. Legal tender laws can explain what is used as the unit of account, but cannot predict when a money will circulate at a premium and when it will be hoarded. For example, during the years of 1792-1833 only the large denominations of the undervalued currency, which was gold and Spanish dollars, circulated. Most of the gold was exported, but for several years the Spanish dollar, which contained more silver than the U.S. dollar, circulated at a premium. More important is the fact that small denominational coins of the undervalued money in this period did not circulate:

The small change available during this period consisted of U.S.
silver coins and a substantial amount of Spanish coins.
The small-denomination Spanish coins contained less
silver than the U. S. coins (just the opposite relationship to
that between the Spanish and U.S. dollars), and, as our
hypothesis predicts, the undervalued small U.S. coins
had trouble circulating.

The reason for this has to do with the costs incurred from paying for premiums on smaller denominational coins which are usually higher than on larger denominational coins. This causes citizens to bundle the smaller denominational coins together to complete transactions and they disappear:

Generally, the smaller the denomination, the more costly it is to pay the fractional part of a premium. Because of this additional cost, traders are not likely to pay premiums on individual small-denomination coins. Thus the public is not likely to use these coins as a medium of exchange and is, rather, likely to collect them into large quantities that will exchange at a full premium; that is, individual units of small-denomination currency will tend to be bundled and taken out of circulation.

Similar reasoning can be used to support our position that large denomination notes such as the $100 bill will circulate at a premium, particularly against lower denominational notes and digital dollars. While it has already been seen that the fees, taxes, and negative interest rates that will be levied on digital money will cause physical dollars to exchange at a premium, it should be emphasized that this will also be the case when compared to lower denominational notes. As the Wall Street Journal states:

A million dollars in $100 bills weighs approximately 22 pounds and can fit comfortably into a large shopping bag. With $10 bills, it isn’t so easy. Think of lugging around 220 pounds in a giant chest. Hoarders and tax evaders would find small notes proportionately costlier to count, verify, handle and store. The use of cash could be further discouraged by putting restrictions on the maximum size of cash payments allowed in retail sales.

This implies that costs, particularly transportation and transaction costs, will be much higher for lower denominational notes than larger notes. Since banks cannot be trusted to store $100 bills by market participants who wish to exchange these notes, holders of them will prefer to keep them stored with as little cost as possible. Thus it is easy to see that $100 bills will be the preferred denomination in terms of storage. Counting notes will also pose a considerable cost if extremely small denominational notes such as $1, 5$, and $10 bills are used, especially for larger purchases. The same logic applies to verifying the authenticity of physical cash, as well as handling and transporting it. This will hold true for market participants wishing to take advantage of their holdings of $100 bills because we can see the same results when applied to criminals using $100 for illegal activities. Peter Sands makes this clear:

High denomination notes are the preferred form of cash for conducting illicit activities where significant values have to be transferred, stored, or moved. As an indicator of the incremental value provided by larger denominations, criminals will pay a premium for €500 notes and US$100 bills often attract an exchange rate premium relative to smaller US$ denominations in many emerging markets.

It has been seen that due to costs incurred by holding and exchanging digital dollars and lower denominational notes in an economy consisting of negative nominal interest rates and legal tender laws, it will be advantageous for holders of larger denominational notes such as the $100 bill to use them due to the premium they will command because of these transaction costs, as well as inflation. Gresham’s Law in its popular form does not hold true, as the historical evidence and theory demonstrate. Instead of one currency disappearing from circulation, the undervalued currency will likely be traded at a premium unless the costs of using that money in exchange are too high.