Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Mon, 17 Aug 2009

Economics of counterfeit notes

There has been much alarmed discussion in the press about the counterfeit Indian rupee notes allegedly being smuggled into the country from across the border. As I see it, the barriers to counterfeiting currency notes are economic and not technological.

Introducing more and more complex features into the notes does not make counterfeiting impossible. What it does is to increase the scale economies in printing by requiring larger and larger initial investment and therefore larger and larger scale of production to make the printing of counterfeits economical. Scale economies are not a problem for the government itself because it anyway prints notes on a very large scale.

Scale economies need not deter the counterfeiter; it only requires the counterfeiter also to operate on a large scale. The problem for the counterfeiter is that the distribution of counterfeit notes is characterized by large diseconomies of scale.

It is pretty easy to distribute a few hundred counterfeit notes with very little chance of detection. Distribution of a million counterfeit notes however requires a distribution network that is very difficult to set up and operate without being detected.

This combination of scale economies in production and scale diseconomies in distribution imply that there is often no viable scale of operation for a private counterfeiter. The total expected cost of manufacturing and distributing the counterfeit note approaches the face value of the note itself.

Counterfeiting by a foreign government is only slightly different. To the extent that they can use the equipment used in their own note printing operations, counterfeiting may be economically viable for them at lower print runs. More importantly, if their goals are not purely economic, the profitability of the operation is not an issue.

However, the problem of the distribution channel is still an issue. The experience of German counterfeiting of UK currency notes during the second world war suggests that the technical quality of the counterfeiting is not the real problem. How to get the notes into enemy territory in large scale is the critical issue. The German experience suggests that using the espionage network to put the notes into circulation only compromises the espionage network itself.

Often, the goal of putting counterfeit notes into circulation in enemy territory is not to make a profit but to disrupt the enemy’s economy by making people distrust their own currency. The strategy of the Indian government and the RBI to deal with the problem of counterfeit notes quietly and without spreading panic is therefore a very sensible one.

For a profit motivated rogue government, the most attractive currency to counterfeit is the US dollar. An estimated 70% of US dollar notes circulate outside the US; many users of the currency are not very familiar with it; the design of these notes is relatively stable; and finally, dollar resources are very valuable in international trade.

Anecdotal evidence suggests a greater percentage of counterfeit US dollar notes (at least outside the US) than in most other currencies. Yet the percentage of counterfeit notes is still quite manageable. I think therefore that the fears that are being expressed in the Indian press about counterfeit rupee notes are excessive.

Posted at 21:15 on Mon, 17 Aug 2009     View/Post Comments (7)     permanent link